The great thing about index funds is that they are “set it and forget it” investments. But does that make sense for a retirement plan?
Absolutely, and for a number of reasons. First, though, you should understand what an index fund really does.
An index fund owns a selection of investments, much like a typical mutual fund. The difference is, nobody is picking and choosing those investments. There is no money manager in the background trying to pick winners out of a heap of stocks.
Rather, in an index fund you own the whole market, whatever market that fund is tracking. If it’s an S&P 500 index fund, you own the entire S&P 500 — all 500 stocks.
If the S&P 500 Index goes up, so does your fund. If it goes down, your fund falls too.
Likewise, you can buy an index fund that tracks the broad bond market, or foreign developed companies, or emerging markets stocks. Even foreign bonds and commodities.
The upside is cost. You get exposure to an entire asset class with no intermediary in the form of an active manager, so they are cheap and easy to hold. Since there’s little turnover in the fund, there’s almost no drag from buying and selling, no commissions and no real reason to sell it.
Unless you need to re balance. That’s the “secret sauce” that helps you get an edge on just holding stocks alone. As some asset classes are challenged, usually other investments go up.
Re balancing is simply programmatic selling of a portion of the winners you have in order to buy the relative “losers” in your portfolio. By taking gains automatically, you are able to bank those winning investments and get ahead of the general market curve.
That’s why index funds are so powerful in a long-term retirement plan. Automatic reinvesting and re balancing, low cost management and minimized tax impacts keep money in your portfolio.