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An index fund is a vehicle that is designed to be a safe or fool proof method of investing in the stock market. This level of safety is supposed to be achieved by investing in an index a list of stocks that meet certain criteria rather than active stock picking.
Index Funds 101
A traditional mutual fund is actively managed that means a manager or team of managers picks the stocks that it invests in. An indexed fund is automatically managed only stocks that meet the criteria are purchased. Any stock that cannot match the criteria is automatically sold. Nobody actually makes a decision to buy or not to buy anything.
The most common method of indexing is stocks from the largest companies that meet a certain criteria. An S&P 500 would invest only the stock of the 500 largest publicly traded companies in the United States. In addition to eliminating human shortcomings from the investment process this is supposed to offer diversification. The S&P 500 fund would invest in a wide variety of industries which would theoretically shield it from losses.
Index funds can offer a high fairly stable return over time. If Jeannie invested $5,000 in an S&P 500 index in 1980 and kept it until 2011 her funds would have grown to $39,651 based on an average rate of return of 12.61%. There are some risks from indexes that you should be aware of.
Potential Losses from Indexes
The big problem with indexes is that they can be very vulnerable to market fluctuations and bear markets. An S&P index fund have lost 37.22% of its value in the year 2008 because of market losses. Yet it would have regained all of those losses over the next few years.
That means an index fund is an excellent long term growth investment but not a good method of parking money. You should put funds you may not need until years in the future (such as your retirement nest egg) in such vehicles. You should never put the money that you might need real soon in one.
Index funds can be particularly dangerous for persons saving for retirement with non-insured vehicles such as IRAs and mutual funds. Such people can lose all or even most of their investment through market volatility. These funds can also be very bad for retired people that are relying on investments for a large percentage of their income. If most of Jeannie’s money had been in an S&P index in 2008 she would have lost most of her savings.
An Indexed Fund that Offers More Protection
There is a way that you can invest in indexed funds and get an added layer of insurance protection and increase your amount of tax deferred income. An indexed annuity is a hybrid investment that combines an indexed fund and a fixed-rate annuity contract.
The way it works is that some of the money is invested in the index through a sub account. Some of the funds are also invested in a fixed-rate annuity which provides guaranteed income. This will provide the annuitant with some income. Any profit made from the index is reinvested in the annuity so it will not be lost and have insurance protection. This can grow your retirement nest egg while lowering the risk. Any gains would be tax-deferred because all money invested in annuities is tax-deferred. That means no taxes are due until the money leaves the plan.
This arrangement is not perfect but it can reduce the risks associated with indexed funds. It can also provide an investment that effectively manages itself. Persons interested in any sort of indexed investment should always carefully research them before buying one. There are serious risks associated with them even though they are very safe investments.
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