Saturday, March 31, 2018

Index Funds

I have been speaking with my daughter and other young adults about how to invest for retirement. I strongly recommend index funds. In particular, I recommend choosing an index fund based on the S&P 500 or some other measure of the American stock market as a whole.

My father said that if you invest in the stock market, you will get rich when everyone else gets rich. In times of inflation, stock values will automatically ramp up to keep pace. Fixed interest investments such as bonds, however, will require your constant attention.

If corporations respond to growth in the economy by rewarding shareholders rather than giving raises to workers, workers can benefit by becoming shareholders. Be warned, however, that workers who invest their retirement funds into the stock of their own employers risk losing both their income and their retirement simultaneously if the employers suddenly go out of business. Workers are better off investing in the economy as a whole by choosing a diversified index fund.

My father also said that if the stock market collapses, you will become poor when everyone else becomes poor. I would not worry about this because you can ride out the dips if you have no immediate need to withdraw your funds. A diversified collection of stocks held for decades is no riskier than bonds held for the same period.

Once when I spoke in praise of investing in the stock market, my uncle protested that he had lost almost half of his retirement funds due to a stock market dip. I responded that this was because he had not been investing in the stock market over his entire career. In fact, he had invested his retirement funds very conservatively over his lifetime until he decided to move everything over to the stock market just at its peak before a collapse.

Dollar cost averaging is a technique in which you invest a fixed amount in the stock market with every paycheck. This buys you a lot of stock when stocks are undervalued and less when stocks are overvalued. In the long run, this works out in your favor.

When it comes time for retirement, most recommend re-balancing your portfolio to invest some of your income in safer investments. There are a few who say that you should keep it in the market and let it ride. Keep in mind that you will probably live for at least a couple of decades past retirement.

Some people recommend investing in other inflation-proof assets such as real estate. Being a landlord, however, requires more effort than you expect. Even if you hire a company to manage your rental properties for you, you now have to keep an eye on the management company to ensure they are continuing to serve your interests.

Investing in individual stocks can also be more effort than you expect. After studying the complexities of corporate finance in graduate school, I realized I was better off focusing my attention on my day job and other pursuits. With dollar cost averaging into an index fund, you can set up automatic contributions once and then concentrate on more important matters in your life.

You might consider letting a money manager pick individual stocks for you. On the whole, these actively managed funds perform about the same as index funds. They cost you much more, however, as the managers take their fees.

So do not be a contrarian. Invest in an index fund. Set it and forget it.