The Case For Index Funds

NEW YORK (MarketWatch) -- "Ever wonder why fund managers can't beat the S&P 500?" Michael Douglas asked in the 1987 movie "Wall Street." If you have your money in a mutual fund administered by an investment manager, chances are you have indeed wondered.

Even the smartest Wall Street pros are wrong now and again, and when they are your nest egg takes a hit. Not everyone has the mettle to withstand this kind of risk. If you prefer the safer approach to investing, you can't do much better than index funds, says P.J. DiNuzzo, president of DiNuzzo Investment Advisors in Beaver, Pa.

Index funds aren't in the business of trying to beat the stock market. Instead, they exploit the averages by following the market as closely as possible.

Most broad-market index funds work by buying all of the stocks in a particular index in amounts proportional to each company's size and value. Take the Standard & Poor's 500 index, for example. An S&P 500 index fund will invest a percentage of your money in all 500 stocks, based on how each company's shares are weighted.

By spreading your money around, index funds minimize the chances of it evaporating overnight if a particular stock dives. The other nice thing about the majority of index funds is that money is dispersed based on a mathematical algorithm, so your stock doesn't have to be managed by a flesh and blood analyst, who charges a percentage on each trade.

The gains made by investing this way are less dramatic than more aggressive investment strategies, but they add up over time. DiNuzzo recommends that beginners put 60% of their money in a total stock market index and 40% in a total bond market index. If you do this and let your money weather the ups and downs of the market for 10 years, DiNuzzo says you can reasonably expect to make 8% to 10% annually.

Buying and holding stock through market upturns and downturns puts the probabilities on your side, says DiNuzzo: "Your portfolio stands a better chance of making money if you leave it in an index fund as opposed to an actively managed fund."

By Marshall Loeb