Why Index Funds Are Your Best Retirement Option

by Jason Unger

When it comes to picking your investments for your retirement accounts, you may or may not have a choice.

Most likely, your company’s retirement plan limits — or heavily suggests — what you should invest in. But for your Roth IRA, you have the freedom to determine where your money is going.

If you’re looking to spend less time managing your retirement accounts and still come out near the top with your long-term investments, look to index funds.

Index funds are the investments that professional retirement planners don’t want you to invest in. They’re not actively managed by a fund manager, they can never beat the stock market, and they rarely change their holdings.

Guess what? Those are all great things.

Because index funds are consistent in their investments, they have low turnover (buying and selling) fees. Thanks to fewer transactions, they don’t need a money manager who takes a cut of their earnings (win or lose).

And despite the fact that they will never beat the stock market, index funds will outperform almost every other mutual fund over time.

Your 3% Chance of Winning with Actively Managed Funds

The NY Times recently ran a fascinating article with near-proof that index funds are the best retirement option for most investors.

From The Index Funds Win Again:

[Mark Kritzman, president and chief executive of Windham Capital Management of Boston,] calculates that just to break even with the index fund, net of all expenses, the actively managed fund would have to outperform it by an average of 4.3 percentage points a year on a pre-expense basis.

The chances of finding such funds are next to zero, said Russell Wermers, a finance professor at the University of Maryland. Consider the 452 domestic equity mutual funds in the Morningstar database that existed for the 20 years through January of this year. Morningstar reports that just 13 of those funds beat the Standard & Poor’s 500-stock index by at least four percentage points a year, on average, over that period. That’s less than 3 out of every 100 funds.

Three! Only three out of every 100 funds beat the S&P 500 index over 20 years when you take into account fees and expenses.

The argument isn’t that index funds are always going to earn you the most on your investment; they may not. But what are the odds that you’ll be able to pick the 3% of actively managed funds that will perform better over the long haul?

“By definition, therefore, such a fund could not have been identified in advance,” says Kritzman. “It is very hard, if not impossible, to justify active management for most individual, taxable investors, if their goal is to grow wealth.”

Conveniently, index funds are perfectly designed for the automatic retirement investor. Where actively managed funds will buy and sell in response to changes in the market, thus affecting their performance and envoking fees, index funds will do whatever the market does — and your automatic contributions will ride the wave.

{ 1 comment… read it below or add one }

Jason Unger April 5, 2009 at 2:11 pm

One of the obvious benefits of index funds (that I failed to mention) is how relatively simple they are to understand.

In a market where most professionals confuse average investors, it’s refreshing to have an option that can be easily understood.

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