When to Buy an Index Fund

An index provides a sample view of some section of the stock market. The Standard & Poor's 500 Index, for instance, measures the price movements of 500 of the largest, most successful, U.S.-based companies. The Nasdaq Composite Index measures the price movements of companies on the Nasdaq Stock Exchange, which is dominated by technology stocks. Japan's Nikkei 225 Index tracks the performance of the top companies on the Tokyo exchange.

Q:What are index funds?
A: Index funds are mutual funds that include all the companies that make up a particular index. For example, a Standard & Poor's Index Fund would be a fund that held stock in every one of the 500 companies in the Standard & Poor's 500 Index.

Buying an index fund is a good move for two reasons: As long as you choose an index representing a broad cross section of industries, it can protect you from sudden downturns in one particular industry, and it limits the taxes you will have to pay.

1. Spreading Your Risk

By buying an index fund that represents a wide array of industries -- such as the Standard & Poor's 500 Index -- you avoid having all your eggs in one industry basket. That broad exposure, or so-called diversification, is particularly recommended if you are just starting out as an investor and you want to have one good core investment. The S&P 500 Index Fund, for example, will give you a cross section of all the major U.S. industries, from automobiles to household products to technology. The Standard & Poor's Mid-Cap Index Fund will give you a cross section of 400 of the strongest medium-sized companies in a wide array of industries.

Be careful, though. Not all index funds track truly broad-based indexes. For instance, some index funds only track certain geographic areas such as Japan or certain types of companies such as small value companies. If you want to buy an index fund that ensures industry diversity, avoid funds other than those that track the S&P 500 or the S&P Mid Cap 400.

2. Limiting Your Taxes

Investing in an index fund could be the next move you make after maximizing your contributions to a tax-deferred retirement plan. In other words, if you already have ample investments in a Roth IRA and a retirement plan at work, and and you still have money to invest, index funds are a smart second step because they will bring you big tax savings.

Why is this? Well, in a regular actively managed fund, the fund manager is often buying and selling companies, wheeling and dealing, trying to sell companies at the right price and buy others for a bargain. And unless you hold that mutual fund in some sort of tax-deferred account, you have to pay taxes on all that trading activity. With an index fund, however, there is no manager to buy and sell the companies. The fund simply rides along with the fate of the index. That means the index remains constant throughout the year and only changes at specific times, when the people who compile it change its composition or "weightings" to reflect changes that have occurred in the value of the companies they track.

To illustrate the tax-sheltering advantage of indexed funds in action: The Vanguard Index 500, a fund that mirrors the S&P 500 index, posted a five-year average return of 18.64 percent. The tax-adjusted return for this fund was 17.78 percent. So less than 1 percent of your mutual fund profits would have gone to taxes if you had invested in it. This compares very well with something like the Fidelity Select Technology fund where more than 6 percent of your mutual fund profits would have gone to taxes during the same time period.

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