Beat Most Investors By Indexing

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The easiest way to beat most investors and grow your wealth is based on the concept of compound interest or growth by investing in index funds.  This is a simple concept that all investors should understand.

Consider for example a mutual fund that buys every stock trading on a major US exchange, investing in each company a percentage equal to that company’s percentage of the total value of the US stock market.  Thus, if the market value of Apple (calculated as the share price multiplied by the number of share outstanding) is $500 billion and the total market value of all stocks is $10 trillion, then the index fund puts 5 percent of its net worth into Apple and so on for the other stocks.

A fund like this that replicates the composition and investment results of a specific pool of securities is thus called an index fund, and investors who buy such funds are called indexers.  Moreover, any investment that mimics a specific market is called ‘passive’ as opposed to an actively managed fund.  The S & P 500 for example (see graph below) consists of 500 stocks listed in the NYSE and NASDAQ, and is considered to be one of the best representations of the U.S. stock market, not to mention being a bellwether for the U.S. economy.

Besides its simplicity, another benefit from indexing is the returns.  A 2009 study by Morningstar for example, indicated that after adjusting for size, risk and investment category, only 37 percent of active funds had beaten their benchmarks over a 10 year period.

Then there is the cost.  Most funds have annual expenses of less than 0.2 percent, compared to the typical 1 percent annual management fees imposed by active funds.  Thus, the annual returns of a typical index fund over the past few years after costs and inflation is around 6.7 percent, compared to 4.7 percent for active funds, or a third more.  Then there are the brokerage fees to consider.  I would recommend using M1 Finance because not only is it a simple and effective investing app but it also gives you real value for money, not to mention giving you a variety of index funds to choose from, all at a $0 commission cost.  You can check out M1 Finance here.

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