How To Maximize Your Stock Market Return Rate With Little Risk? By Investing In Index Funds

July 8th, 2009

Maximizing Stock Market Return Rates

Have you opened up to the advantages of budgeting and now have some extra money to invest in the stock market? Do you want that money to keep growing? Do you dream of getting to a point where you have built a strong enough portfolio for you to retire comfortably without worrying whether or not Social Security will still be around? Start investing now, and you can start earning more money.

Let’s be honest here, when we mention investing in the stock market, we know that a lot of people think we’re talking about becoming an overnight millionaire. This is not what we’re going to talk about here. But that doesn’t mean that we should shy away from the fact that practically everybody, in the beginning of their investing career, thinks they’re Warren Buffet and attempts to beat the market. Only very few succeed, and that’s exactly why those few make so much money and have so much fame. You should recognize that.

For most of us, the very act of trying to beat the market amounts to a virtual guarantee that we won’t, if only because of transaction costs and taxes. Even if you choose to be a stock picker, it’s a skill you can only develop over the years; market timing and momentum investing are, at best, educated guesses and at worst, pure gambling: in the short term, there’s almost no reliable way of predicting in what direction the stock market will go.

There are many different ways to invest money. Which should you choose? You can invest in stocks, bonds, mutual funds, commodities, derivatives, real estate, currency, money market funds, or even peer-to-peer lending. Most of these investment vehicles have money-making potential, but some will earn you more than others. Why is it generally recommended to choose to invest in the stock market over the other investments?

The simple answer is that the historical return of the stock market is about 10 to 13%. That means that if you invest over the next 30 or so years in the stock market, on average you’ll earn between 10 and 13%, and yes, that rate includes the down years. By contrast, if you invest in bonds and CDs or certificates of deposit, you’ll be lucky if you can get 6%, although the latter investments are considered safer than stocks.

Besides, although stocks are usually more risky than bonds or certificates of deposit, you can control that risk and minimize it. Simply diversify your portfolio and you cut down on a lot of that risk that could potentially lose you a lot of money. Invest in stock mutual funds, and you can instantly diversify your stock and not have to worry about choosing and researching your stocks.

At this point, though, it deserves to be pointed out that mutual fund returns haven’t been that great in recent years, and it’s hardly a recent phenomenon. The average mutual fund return has failed – over the long-term – to beat its underlying index (which you can invest in passively relatively cheap). It’s widely reported that 80% of mutual funds fail to beat the market. Pretty shocking isn’t it?

Fortunately, there’s a way for you to earn the same returns as the market (thus, above-average returns) with virtually no effort? And the answer is something that people rarely think of because it’s not sexy and doesn’t generate headlines: index funds. While most people assume that investing in index funds is settling for average performance, the stark reality is that investing in index funds yields above average returns over time. Warren Buffet, a notorious investor who is also a billionaire because of great business and investing decisions, recommends investing in index funds.

Investing in index funds

A mutual fund index is an investment portfolio that matches a target “index” or benchmark. One of the most popular index funds is the one that’s made up of all 500 stocks in the S&P 500. The index is a passively managed fund, meaning that the fund is not actively managed by a person making decisions. All the index does is replicating the performance of the 500 stocks in the S&P 500. Odds are, buying an index fund made up of all the stocks in the market will result in you doing better than the vast majority if professional fund managers out there. Plus you don’t have to agonize for months over which stocks to buy and when.

How’s a non-managed fund able to beat Wall Street professionals? Simply because an index fund has lower expense ratios: over time, the savings that you get from those lower expenses really add up. On average, it’s estimated that the expense ratio is roughly 1.9% for most actively managed funds, as opposed to a 0.1% ratio for index funds. Index funds are notoriously low maintenance: they require very little time and resources to run.

Index funds also offer great tax advantages. Since all they do is they simply replicate a benchmark, there are fewer transactions and turn overs. To you, the investor, that translates into less transaction fees. And in turn, because the fund sells investments much less frequently, you report fewer capital gains stemming from stock sales. Ultimately, lower turnover means fewer costs to the investor.

Diversification is the last key advantage we’ll examine here. If you look at an index such as the Wilshire 5000, the stocks that it’s made of fall into so many different categories, since the fund holds approximately 5,000 different stocks that come in all sizes and from all sectors. In contrast, a fund that holds, say, 100 stocks may be exposed to much more volatility than this Wilshire 5000.

Despite the many advantages, index funds are not exactly perfect. The biggest criticism is that they perform just like the market. In short, the fund has no chance of beating the stock market; it’s simply follows the market movements. Why some people consider this a disadvantage is beyond me!

Index funds are a good way for investors to hold and let go of their investments for the long run. They are portfolios with a wide range of stocks or other investment vehicles. They provide, in most cases, diversification for individuals seeking to make their portfolio safer and less volatile. Although index funds do not provide out-performing gains, they do allow an investor to sit back and let the fund take care itself for the long term.

Finally, it’s good to know that brokers don’t make a lot of money off of index funds. That is why you won’t hear this from them. So if you are wondering where to maximize the return on your stock market investments while incurring little risk, index funds are your answer.