Introduction: Mutual Funds vs Index Funds
Index funds have become a trend over mutual funds during the past few years. It reminds of Cole Porter’s song: “Folks in Siam do it, people say in Boston even beans do it, even lazy jellyfish do it.”
Yes, apparently, everyone has fallen into index funds. Since 2010, investors have withdrawn billions from actively managed funds, and invested this and even more in mutual and exchange-traded funds that are tracked by the index. But one of the most important rules of an investor is that if everyone thinks the same way, it’s probably going to start happening exactly the opposite. So should investors invest in index funds or mutual funds?
ROTH IRA: Which to Choose – Mutual Funds or Index Funds?
One of the best real examples of the mutual and index funds is described in “A Random Walk Down Wall Street” by Burton Malkiel. In his book, he made a comparison investment between mutual and index funds. He started at $10,000 in the S&P 500 index fund and invested the same amount in an average mutual fund at the end of 1969. By 1998, his original amount was increased 31 times in the index funds (giving him $311,000 in profit) and only $171,950 in the mutual fund. Huge difference, is it not?
But what worked 30 years ago might not work today. The market is constantly developing. According to Morningstar, if you invest in the “developing” companies, rather than a famous giant, you can overplay index funds. We have made our own calculation: let’s assume you have $10,000$ and wanted to buy a share of Apple in 1982. In the same period, 1 share cost $0.23. We will consider the average to be $0.32. With $10,000, you could have bought 43,478 shares. Today, one share of Apple costs $364.11. Your profit would be over 15 million dollars for a similar period of time, as Burton did.
As a result: saying that index funds are better and more profitable in investment would be not correct. You can choose between them for your Roth IRA by following a simple table below:
Comparison Between Index Funds and Mutual Funds
- Index funds are much more volatile than mutual funds, but you earn much less. The strategy is to go slowly. That is why index funds also called “lazy”; the investor does not have to do anything. They just sit and wait. Unfortunately, because of such strategies, some key figures of Wall Street claim that investors give up on investment as soon as they enter Index funds. Mutual funds can have higher volatility, but it does not mean they are bad. You can calculate them by a beta coefficient and be ready for changes.
- Mutual funds liquidity and Index Funds can be very different from stock to stock. Indeed, SEC prescribed the minimum amount of liquidity that the company has to hold. Passive ETF can be even riskier in a crisis than mutual funds. Sanford C. Bernstein & Co. already warned: if thousands of ETF investors will try to sell their share by cell-phone at the same time, it will be the disaster.
- Index funds require a minimum investment, while mutual funds are more expensive. In 2020 the mutual funds minimum investment varies from $500$ to $5000, while Index Funds even do not have minimum fees. You can start with just $1.
- Both Index funds and mutual funds have a prospectus. The prospectus is the document providing information about an investment. SEC strictly controls it and makes sure all investments are available to the public, so the prospective investors can make informed thoughtful decisions.
- Index funds are famous for their diversification. When you buy only one share in Index funds, you get access to all stocks. At the same time, saying that mutual funds are less diverse would be a mistake: equity mutual funds, bonds (fixed-income funds), money market debts (so-call short-term debt), and hybrid bonds are all options. Sometimes being too diverse does not provide good results. If the portfolio is full of shares in stocks that are not profitable, or if it is focused on an industry that is very specific, this might cause a problem. Investors should have a well-balanced portfolio, and being too diverse or not diverse at all is the same issue for losing money.
How to Invest In Mutual Funds and Index Funds
We have made simple steps and tips for you to make safe investments.
How to Invest in Mutual funds:
- Start with the minimum amount. If it is $500, start with it- do not try to invest all your money at once if you are a beginner.
- Try to diversify your portfolio among multiple stocks. Do not invest all of your money in one company.
- Start SIP: automated monthly investments
- For a start, try to invest without opening DMAT account
How to Invest in an Index Fund:
- Start by checking your personal 401(k). If you do not have a 401(k), you will have to open an IRA.
- Start searching for a brokerage account.
- Make a note of what market you want to focus on and invest in.
- Check the investment amount (it can be 1$ or even 2000$)
- Do not look for an expense ratio bigger than 0.5% as a beginner
- Fund your account with money and start automatic contributions.
There is no answer that is better: mutual funds or index funds. It all depends on the style of your investment and “what investor” you are. If you prefer active management, start with mutual funds. If you just want to have money “working for you” without digging into the process, index funds will be for you.
Whatever you choose, you will need a trustable platform for your investments. If you hesitate to find, we suggest trying Einvestment. We have years of experience in investment, and we create customized special plans for each individual according to their needs.