19. Index Funds Part 1
Posted on January 6, 2019
Today’s Letter from Grandma Sylvia
I’ve written an introduction to index funds in Post 8, so now I’ll provide more details about index funds and about indexes/indices more generally. Either word -–indexes or indices—is used widely although there are preferences depending on the specific field of study. I’ll probably use them both in this letter.
Now for some examples.
The Big Picture
Generally, an index is
an indicator, sign, or measure of something.
(See notes at end for online references.)
We’ve all heard of a book index, index cards and index fingers.
Most of us have heard of the body mass index (BMI) or the consumer price index (CPI).
The BMI is:
a person’s weight in kilograms (kg) divided by his or her height in meters squared.
As we work to stay healthy, we look at our BMI and try to stay within a healthy range.
The CPI is
a measure that examines the weighted average of prices of a basket of consumer goods and services, such as transportation, food and medical care.
As we work to stay within our budgets, we hope the CPI doesn’t rise, indicating higher costs for food, etc.
Creating a book index is so important there is an organization, American Society for Indexing, for those who do this kind of work.
I found so many different kinds of indices I wanted to list a few to show the wide range of applications:
- Organization for Economic Cooperation and Development Better Life Index
- Index of Nonmanufacturing Activity
- Organizational Health Index
- Consumer Sentiment Index
- Wage Price Index
- Index to Early American Periodicals
- British Humanities Index
- LexisNexis Government Periodicals Index
- Index of Protected Areas of South Africa
Here are some quotes I liked about indexes:
Beauty is the index of a larger fact than wisdom.
Holmes, Jr., Oliver Wendell
Speech is the index of the mind.
Seneca the Younger
Most of the mutual fund investments I have are index funds, approximately 75%.
Charles R. Schwab
When you look at the results on an after-fee, after-tax basis over reasonably long periods of time, there’s almost no chance that you end up beating the index fund.
David F. Swensen
I’ve written about my use of index funds. After starting out buying individual stocks, I found it was easier for me to invest in index funds. Then I would own some small part of the many companies held by the index funds. I liked having ownership in so many companies and knew I could not afford to buy a reasonable number of shares in all of them. Today, I still have some individual stocks, but very few.
Today’s Topic: The Financial Markets and Index Funds
In the early financial markets there were stocks and bonds. Then mutual funds were created as baskets of stocks, or bonds, or a mixture of both. At first mutual funds were actively managed by people who had strategies of what to buy and when to buy and sell. These actively managed funds were sometimes very successful, but often the management fees took a toll on total return. There are still some very good actively management mutual funds, but the investor needs to be very careful to be sure the total return after expenses is a good choice.
Index funds are also mutual funds, but they simply follow, or mirror, an index. The companies that are in the index are the companies in the index fund. It’s a little more complicated, but the general idea is that the fund is passively managed: no complex decisions on what to buy and when to buy and sell. This helps lower the expenses considerably.
Here, I’m only giving a brief overview of index funds, but interested readers can find so much more by going online with key words: indexes and index funds. I’ll also write a somewhat more indepth account of one index in the next post and some of the index funds that use that index: Post 20. Index Funds Part 2.
For now, it’s good to know that there are a huge number of indexes. Three of the most well-known ones are:
The DOW Jones Industrial Average (DJIA). It has 30 stocks, but represents about one-quarter of the value of the entire US stock market.
The Standard & Poor’s 500 (the S&P 500). It has 500 stocks and represents about 80% of the total value of the entire US stock market.
The Nasdaq Composite Index (NASDAQ). It has over 3,300 common equities (including stocks, real estate investment trusts, and others). Some of the companies are not US based.
According to Money Observer, there are now 70 times more market indices than listed stocks in the world: 3.3 million stock market indices (see reference at end).
Many people simply buy three index funds:
- the total market index fund: a fund based on the total market index
- the total bond market index fund: a fund based on the total bond market index
- the total international market index fund: a fund based on the total international stock market index.
Many investment firms have their versions of these index funds and it is easy to look at Vanguard, Schwab, Fidelity, and others to see what their funds cost and what their expenses are.
♦ Index funds are mutal funds that simply follow an index.
♦I ndex funds are passively managed funds with low expenses.
♦ The companies that are in the index are the companies in the index fund
♦ To invest simply, buy three index funds that track the total stock market index, the total bond market index, and the total international stock market index.
I’m still working on my taxes, but I have almost all my forms organized to send to my tax preparer. Tomorrow I’ll take a break to get more exercise.