Want to start with — or switch to — an easy investment strategy?

You can do that with index mutual funds, which are relatively easy. You don’t have to pick individual stock or bond funds, just an index of some kind. The Dow Jones Industrial Average, which we often hear referenced, is one such average, made up stocks that are both in the industrial category and among the 30 blue-chip companies followed by Dow Jones.

By: Robert F. Abbott, freelance writer and author

You can also find indexes (also called indices) that cover other industries or sectors, such as health care and transportation; you can find bond indexes, dividend indexes, and a host of others.

Generally, then, you’re buying sectors or categories of stocks/bonds, rather than individual companies or bond issuers. As the name suggests, an index fund replicates or copies a basket of stocks or bonds. For example, some index funds are made up of all the stocks in the S&P 500, which means you own a piece of all 500 stocks in that index.

When I say different funds covering the same index, I’m talking about the offerings of different mutual fund companies (such as Vanguard, Fidelity, and so on). Later, we’ll consider weighted versus unweighted indexes.

Advocates of index funds point to two main advantages: lower cost than most other types of mutual funds, and simplicity.

Low Cost of Index Mutual Funds

When a mutual fund company puts together an index fund, it doesn’t need to pay much for management because the selection of companies will be automatic or mechanical. It will buy stock of each company in any particular index. And, it doesn’t need to pay for advice from experts, because any changes that do occur again are mechanical.

Returns and losses on index funds vary, depending on the nature of the index. We would expect the price of a fund made up of small cap stocks to bob up and down more than a fund made up of large cap stocks, since small caps are inherently more volatile.

So, index funds usually cost less (lower management fees) than funds which require their managers to select individual stocks or bonds. But, don’t take that saving for granted; double check the management expense ratio of every fund you’re considering. You’ll also want to compare the costs of identical funds from different fund companies.

In comparing funds, watch for weighted funds versus unweighted funds. An unweighted fund will contain an equal number of shares of every company in the index; a weighted fund will involve some variation. For example, an unweighted fund will buy an equal number of shares in every company, regardless of price. On the other hand, an equal weighted fund will invest an equal number of dollars (rather than an equal number of shares); this obviously means more shares of lower-priced stocks and fewer shares of higher-priced stocks. There are pros and cons to each approach; use a search engine and ‘weighted index fund’ or something similar for more information.

Simplicity

Some refer to index investing as passive investing, because neither the fund company nor the investor need to actively make investment decisions. The stock of a company is either in the underlying index or it is not, so neither the fund company nor the investor needs to have or act on an opinion. That’s why you also see references to lazy portfolios (a portfolio is a collection of investments held by a particular person).

But, you will need to make some initial decisions to get started:

• How much do I want to allocate to stocks and how much to bonds?
• Which fund company should I choose?
• Which funds within a fund company’s portfolio will work best for me?

For example, if you’re quite conservative, close to retirement, or in retirement you’ll likely want more than half of your portfolio in bonds. Having decided that, you’ll need to decide on short-term versus long-term bonds.

On the stocks side, would you like to hold a broad cross section, such as the Wilshire 5000, or would you prefer the S&P 500 which is made up of bigger (and generally less volatile) stocks?

When it comes to choosing funds within a fund company’s portfolio, you’ll want to avoid overlapping as much as possible. For example, you might buy one bond fund, one large cap stock fund, and one small cap fund. You would avoid adding a balanced fund to those three, since balanced funds contain each of those types already. Keep in mind, assuming you’re using a discount brokerage, that you need not choose funds from just one family; you can mix and match fund companies as you wish.

Perhaps the best way to start with index investing is to look at some of the lazy portfolios discussed online. Using your favorite search engine, simply enter the term ‘lazy portfolio’ (without the quotation marks); that will generate lots of ideas, and help you get started quickly. The Bogleheads Wiki provides examples of two-, three-, and four-fund lazy portfolios (this is for information purposes, not a recommendation).

One final note: Remember that even a passive strategy can backfire. When the stock market plunged in 2008, the S&P 500 index (which includes the biggest and most stable companies) lost almost 40% of its value and took several years to recover. See how it looks on this 10-year chart:

Next, read about Money Market Mutual Funds