Index Funds...The Investor's Training Wheels

The average man doesn’t wish to be told that it is a bull or a bear market. What he desires is to be told specifically which particular stock to buy or sell. He wants to get something for nothing. He does not wish to work. He doesn’t even wish to have to think. -Jesse Livermore

On my birthday during one my wonder years (where I did not have to worry about things like bills, stocks, recession, etc), my father bought me a bike. After the initial excitement of realizing that I got a bike had passed, I realized that I was going to have to learn how to ride the thing. I was a bit timid of the thought of having to get on the bike, maintain balance and pedal all at the same time. After all, I could fall off the bike, get hit by a car in the street or many other bad things.

However, my friend Zack would come by my house on his bike. His house was a mile away from mine and while it took me about 15 minutes to walk to his house, he could get to my house in 5 minutes. Well, now it was my turn, now that I have my bike, I was capable of getting to his house within 5 minutes or less, I just had to learn how to ride it.

So when I tried to ride my new bike for the first time, I hopped on and tried to pedal. Unfortunately I did not understand the concept of balancing on the bike and got approximately 1 foot forward before having to put my feet down to prevent me from falling. After a week after these failed attempts, my father came out and showed me a couple of tricks. He taught me how to coast down a heel to learn how to maintain my balance. Once I learned how to maintain my balance, I learned how to pedal and eventually was able to put the two together and ride my bike.

At the end of the whole learning process my dad told me, "Man, maybe I should have gotten you some training wheels, that would have made this a lot easier and you would have been riding in no time." What, training wheels? Are you serious!? Are you telling me that I could have gotten back at least a few days of failures if I just had training wheels!?

Well, it seems like history repeats itself, because I made the same mistake on my initial entry into the stock market. The simple rule to succeeding in the stock market is to "Buy low, Sell High". Sounded simple enough to do so back in October 2007, Washington Mutual was on its way down and I thought that they looked like a good buy. They were down to $20 from their high of $47 and I just knew when they rebounded, I was going to be able to recover all of my money as well as make a hefty profit.

Well, if you have not followed Washington Mutual's fate, currently they are bankrupt meaning that their stock is worth $0 and no longer exists. Fortunately, I was able to recover some of my money before losing it all, however, the fact of the matter is whether I lost $1000 or $10, I still lost which is the exact opposite of my motivation for investing in the stock market.

Once I realized that my individual stock picking skills were not up to par, I realized that I need to get some "training wheels" so that I do not let history repeat itself. While researching one day, I came across Index Funds.

Index Fund: A type of mutual fund with a portfolio constructed to match or track the components of a market index, such as the Standard & Poor's 500 Index (S&P 500). An index mutual fund is said to provide broad market exposure, low operating expenses and low portfolio turnover.

(Index Fund Definition taken from Investopedia)

*For a list of other common stock indexes, view the Wikipedia page*

An Index Fund is the novice's best investment tool as it offers the following benefits:

1. Allows you to easily diversify your portfolio without having to choose individual funds
   
• Diversification: A risk management technique that mixes a wide variety of investments within a portfolio. The rationale behind this technique contends that a portfolio of different kinds of investments will, on average, yield higher returns and pose a lower risk than any individual investment found within the portfolio. (Cited from Investopedia)
  
2. Low Management Costs
• Since Index funds are managed by computer models that try to purchase the exact funds listed by an index rather than relying on stock analysts, the fee to manage index funds are typically lower than those of other mutual funds.
  
3. Low Turnover
   
• Turnover: The number of shares traded for a period as a percentage of the total shares in a portfolio or of an exchange. (Cited from Investopedia)
• Lower turnover allows you to pay less transactional costs as well as reduce the capital gains tax that you will incur for trading funds held less than a year.
4. No commissions to pay when bought directly from some mutual fund companies.
• Unlike many online stock brokers, when you buy more shares of an index fund directly from the mutual fund company, you do not have a to pay a commission for each purchase. In addition to that, you typically do not have to pay a commission to redeem the fund at a later date.
5. Easier to do Automatic Investing for dollar cost averaging
   
• Dollar Cost Averaging: The technique of buying a fixed dollar amount of a particular investment on a regular schedule, regardless of the share price. (Cited from Investopeida)
  

Although there are many advantages to investing in Index Funds, there are some disadvantages as well.

1. Index funds are designed to perform at the index rate of return
• If you are trying to get a higher return than the rate that is given by the market, you will typically not achieve it by having an index fund.
  
2. As with all investments, there is a risk that the overall index can go down meaning you would get a negative rate of return. (i.e. our current market situation)
3. Investing through a brokerage typically requires a hefty minimum if you are investing in a general account.(i.e. Vanguard requires $3000 for a minimum investment into their funds for a general investment account)
   

Index funds give you the chance to invest in the stock market without a lot of experience or knowledge. I highly recommend that you if you wish to start investing in the market, that you do so using an index fund especially with the market at historic lows. For those who are interested in getting their feet wet with index funds, you can do some research at Vanguard for the different funds they offer.

Do you have any recommendations for Index Funds or any other beginner investments, please share them in the comments below.

Stay Disciplined!