Expert: Steve Hach - 9/11/2010

Question
Hello Mr. Hach
I'm a 24yr old college student with a full time job averaging $1800/mo. I do not have any money saved but I can manage to save some and invest.  I don't know much about the stock market and how exactly it works but after research I came across articles on Index Funds, and from what I understand they are the safest way to invest. The truth is I still don't understand what exactly they are and how they work. Whether there is a minimum purchase that needs to be made in order to create an account and what is the return rate. I would appreciate if you can explain to me what exactly index funds are and how they work and whether or not that is the best option for me. Also where can I buy them and which would you recomend. Regarding return rates, if I invest $1000 how long will I have to wait until I see my money grow and at what rate? I just don't have much knowledge about how all this works. I will appreciate your help.
Thanks

Answer
Hi Ignatio,

Sorry for the delay in my reply.  I was on vacation and forgot to set the vacation auto-responder.

An Index Fund is a basket of stocks set up to mimic the performance of a broader stock index.  It can be either set up as a mutual fund or exchange traded fund (ETF).  Mutual Funds involve more fees and typically these days most people are talking about ETFs when they mention "index funds."

So, as an example, if you want to track the SP 500 index, you could either buy shares in ALL of the companies yourself, or you could buy an ETF that did so and save money on trading costs, commissions, etc.

The idea here is that if you buy the SP index fund, it will tend to go up over time and you will be very diversified, less subject to the vagaries of performance from individual stocks, etc.

Index funds were very popular in the 1990s and early 2000s, but the markets dips and dives over the past 10 years or so have challenged the assumption that the index fund is always the way to go.

However, many investors find the index funds a good way to invest given the limits of their 401ks, IRAs, etc.

For many index funds, and many of the online services that trade them, there is no minimum purchase, you can buy just one share once you set up an electronic account with etrade, tdameritrade, firsttrade, etc.  This is often NOT the case with index mutual funds--where you may have to invest several thousand dollars, pay a commission on the purchase and sale, etc.  This is one of the reasons that ETFs are often more popular/economical for investors.

Rates of return for ETFs depend on the index in question.  An SP 500, Dow, Nasdaq ETF would be down for some periods, up for others depending on when you put money in.  THERE IS NO GUARANTEE FOR STOCK FUNDS AND YOU MAY LOSE ALL OF YOUR MONEY.

You might invest in a gold ETF that is up a huge amount for the past ten years, a China stock ETF that is also up big, an oil stock ETF that was up big and now down, etc.  

There are hundreds of index ETFs to choose from--you can even invest in "short" ETFs which bet that the given index is going to go down so you can make money if the market declines--housing stocks or financial firms in 2007-2009.

I cannot tell you where to invest and I cannot tell you what the rate of return will be.  Anyone who promises you a given rate of return with stocks is not being very honest with you and should be avoided.

I will say this, the most important thing for someone of your age is to save money, avoid debt--like credit cards and student loans, and establish a long-term investment plan.

I would also diversify my investments and make sure that I don't have all my money in stocks, bonds, etc.  

I would suggest that if you were to invest in index funds that you put some money in foreign emerging markets like China, India, Brazil and an established powerhouse like Germany.  

If your company has a stock plan do NOT put all of your money in that stock--think ENRON.

1000$ may not do much in a year or two, but think of this, if you put 1000$/year into investments and do this for 50 years, with interest and average growth you will have a lot of money for retirement.

Get rich quick schemes, day trading, etc. are not the way to go if you can save money with discipline and avoid debt.

Hope this helps, and sorry again for the delay in my reply.

Best,

Steve