Initial Thoughts About Index Funds

[godofgamblers]

Let me restate that I'm a complete novice to investing and stock markets in general, except for the few Economics courses I've taken, so please be kind :P I'm making this post hopefully to make sure my thinking is not flawed, and hopefully get a few suggestions.

After a bit of reading on Index Funds, my understanding is that a Index Fund is basically a mutual fund created by a company that imitates a certain market index. They buy the same proportions as the market index in smaller amounts, thereby creating a mini-market index of whichever they choose, in essence a perfect imitation. The goal of this is to imitate the market perfectly, so they can expect the same yields as said market index.

However, from my initial and not very deep research of this topic, it seems like most of the large indexes normally turned into index funds like the S&P 500 yield a very nominal return. Over the last 3 years it has had a phenomenal yield, but the 2 years before that was a phenomenal loss, making the net yield over the past 5 years about 0%. (I did not go farther than that, just trying to make sure my understanding is correct). However it seems that it's average yield is around 5%, therefore it is a safe long term investment.

Now my question is, why deal with an index fund that has as much variance as that, when banks like ING guarantee 4.15% and longterm bonds guarantee even higher (since we're in it for the longrun with index funds anyway)? Also, a further question is, would index funds be wrong for me if I'm looking for a more high yield high risk type of investment? Should I look more into a mutual fund cosisting of mainly tech, biomed, or any of the more popular booming industries now? Thanks for any and all comments.

[adios]

The S&P 500 index funds are a proxy for the valuation of the overall U.S. stock market which is basically what you stated. Ex post (historical) stock market returns are basically higher than bonds, much higer than you indicate. Ex ante returns (future) who knows? The difference between stock market returns and long term government bond returns is referred to as the equity risk premium. Again, historically the difference is much higher than you indicate. Of course that doesn't mean that these returns will continue. Here is decent link about the equity risk premium:

About the Equity Risk Premium

One thing to note is that we're talking about long holding periods in capturing the equity risk premium, whatever that premium turns out to be.

[PassiveCaller]

OP,

Sample size way too small.

[Dazarath]

Everything sounds good until:
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it's average yield is around 5%

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The S&P 500 has historically returned ~10-12% (I believe) on average. The issue is exactly what PassiveCaller pointed out; your sample size is way too small.

[chardog]

[ QUOTE ]
Everything sounds good until:
[ QUOTE ]
it's average yield is around 5%

[/ QUOTE ]
The S&P 500 has historically returned ~10-12% (I believe) on average. The issue is exactly what PassiveCaller pointed out; your sample size is way too small.

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The OP should also be aware that in general index funds/etfs have far better expense ratios and tax considerations than actively managed funds.

One other thing.. it seems to me that many people assume that someone whose portfolio consists largely of indexed securities is automatically a member of the Church of Buy&Hold for life. Many people who index also employ long term market-timing, increasing or reducing their exposure to the broad market as their timing model turns favorable or unfavorable.

[mwgr5]

"By periodically investing in an index fund...the know-nothing investor can actually outperform most investment professionals. Paradoxically, when 'dumb' money acknowledges its limitations, it ceases to be dumb."
- Warren Buffet

You are the definition of dumb money, to be blunt. You have only taken a few econ classes, so either learn as much as you can about investing and invest intelligently or simply place money in an index fund and earn good, tax efficent returns.

Also, investing in sector funds is a bad idea IMO. Once again, you have limited investment knowledge. When you invest in sector funds your are timing the market so you need to know when to buy and when to sell. The chances that you will do one or both of these tasks incorrectly is high.

Also, the S&P 500 is only a Large Cap Index. There are many other indexes, such as small cap index, international index, emerging markets index. If you have a properly diversified portfolio, you will hold more than just a Large Cap index so your returns should be better if other areas of the market are performing better, which has been the case over the past 5 years.

Other posters have mentioned important info too, such as your limited sample size and the 10-12% historical returns of the S&P.

[sprmario]

Read:

The Four Pillars of Investing by William Bernstein


It should answer all of your index fund questions.

[godofgamblers]

Thanks everyone for the replies. I'll read everything that's been posted on this thread since you guys have read my novice post and actually took the time to reply. Thanks again.

[adios]

You wrote:

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OP,

Sample size way too small.

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To be honest though the sample size supporting what Dazrath stated is small too but I realize most use it and accept it. Just pointing out that the ex post risk premium is determined on a relatively small amount of historical data.