The math of investing is brutally simple: Before costs, investors collectively earn the market’s performance. After costs, they must earn less. In fact, investors collectively trail the market averages by an amount equal to the investment costs they incur. Some folks may get lucky and beat the averages. But the vast majority won’t.
What to do? You might focus on capturing the market’s return at the lowest possible cost—by purchasing market-tracking index funds. Index funds buy many or all of the securities that make up a market index in an effort to match that index’s performance. The funds almost always fall short of their goal, because they charge annual expenses and incur trading costs. Result: If a market index is up 8% in a year, the corresponding index funds might earn 7.8% or 7.9%.
That might not sound great. But it’s a lot better than most actively managed funds, which might earn just 6.5% or 7%, on average, because of their higher costs. Admittedly, by purchasing index funds, you give up all chance of beating the market. But you also eliminate the risk that you will fall far behind. As an added bonus, index funds tend to be highly tax-efficient, because they don’t actively trade their portfolio and thus they are slow to realize capital gains. That means they can be an especially good choice if you are investing taxable account money, as we’ll discuss in the chapter on taxes.
Convinced? You still have a key choice: Should you buy index mutual funds or purchase exchange-traded index funds?
Our Humble Opinion: Here at HumbleDollar, we’re huge fans of indexing, whether with index mutual funds or ETFs. Extraordinarily few investors manage to beat the market over the long term, so why try? With index funds, you may not beat the market—but you’ll beat most other investors.
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