Q: I’ve heard a lot about index fund investing. The funny thing is, I don’t really even know what an index fund is! Can you explain the difference between index funds and regular mutual funds?
It’s always a smart plan to do some learning before committing money! That advice applies to index fund investing too, despite its massive popularity. Since the start of this current bull market, low-cost index fund investing has become much more than just an investment philosophy. It’s almost become an investment religion.
To begin, index funds are types of mutual funds, just like apples and oranges are types of fruit. However, unlike a mutual fund managed by people doing financial research, an index fund’s only goal is to mimic the market.
The index could be designed to track the many hundreds of separate stocks that make up the S&P 500 or it could be made to track the performance of a short list of speculative marijuana companies. In the end, an index fund is nothing more than a low-cost, take-what-the-market-gives-you investment, for better or for worse. You just pick the index to track and the result is essentially written in the stars.
And, since the bull market began almost a decade ago, taking what the market gave you has been a fine result. My consistent advice, however, is for you to periodically assess your risk capacity and to rebalance your portfolio as necessary. There’s always another turn in the cycle.
Q: With interest rates going up, I’ve read that bonds won’t be the place to have my money. What do interest rates rising have to do with how badly or how well bonds will perform?
It always surprises me that investors feel they understand stocks much better than they do bonds. I suppose, like most things, it’s just a matter of familiarity and exposure.
For the record, though, bonds are much simpler than stocks. With stocks, you are a part-owner of a business and you only get what’s leftover after paying everybody else. On the other hand, with bonds, you are simply a lender of money and all that matters is whether or not your interest is paid on time and your principal is paid in full upon maturity.
Now, to visualize the effect that interest rates have on bonds, imagine a teeter-totter. On one side sits a man with a t-shirt labeled “Interest Rates.” On the other side is a woman wearing a shirt that says “Price.” When interest rates go up, the price of bonds swing down.
As it is with teeter-tottering, to lessen the risk of a jarring crash in bond prices if interest rates suddenly rise, the proactive move is to inch your bottom toward the middle! The closer you sit to the center of the teeter-totter – that is, you choose shorter-term bonds over longer-term bonds – the less you’ll experience the up and down swings in your bond portfolio as interest rates rise and fall.
Jason P. Tank, CFA is the owner of Front Street Wealth Management, a fee-only wealth advisory firm located in Traverse City. He encourages questions and comments about future columns. Contact him at (231) 947-3775, by email at Jason@FrontStreet.com and at www.FrontStreet.com