Understand stock and bond index funds for slow, steady growth
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Key takeaways:
- Stock index funds carry the advantage of being passively managed to follow an index (e.g., the total stock market), and thus are tax-efficient with low expense ratios.
- Bond index funds are designed to match trends of a large collection of bonds.
One important investment vehicle to understand when working toward slow and steady growth is the index fund.
An stock index fund is a passively managed fund designed to follow an index such as the S&P 500 or total stock market. A mutual fund, on the other hand, can be simple (eg, a pure stock or bond fund) or complex (eg, a mixture of multiple investment types, including stocks, bonds, real estate investment, commodities and even cryptocurrency).
What makes index funds unique is that they are designed to match a given “index,” or broad collection of investments that give larger market exposure. This helps even out the ups and downs of a single investment, such as holding stock in only one company, and reduce volatility. For example, an S&P 500 index fund would be designed to track 500 of the largest companies participating in the stock market.
Stock index funds also carry the advantage of being passively managed, rather than actively managed. Since they simply track an index, there is no participation or active effort by a fund manager to change the investment strategy of the fund. This means that index funds tend to be less expensive for investors, reflected in their lower expense ratio (the percentage of invested amount “charged” to the investor annually for using a mutual fund). Since broad-based stock index funds tend to outperform most actively managed funds over time, using index funds is a win-win.
Bond index funds are designed to match trends of a large collection of bonds, which are a fixed-income investment type that offer income stream with less volatility than stocks (less risk, less reward). Bonds have different maturity dates, which is the date at which the bond returns principal money and accumulated interest to the investor and stops accumulating additional interest. As individuals approach retirement and rely on retirement income, they tend to shift money from stocks to bonds to mitigate losses and reduce volatility.
Keep in mind when the Federal Reserve increases interest rates, bond prices tend to decrease and, thus, the yield on new fixed rate bonds increase. The inverse is also true, as we are seeing now in the fall of 2024: when interest rates decrease, bond prices tend to increase and bond yields decrease.
For more information:
Chirag P. Shah, MD, MPH, is a soccer and Nordic ski coach, who also practices medicine and teaches in Boston. He can be reached at cshah@post.harvard.edu.
Jayanth Sridhar, MD, is an award-winning podcaster, physician and educator who is chief of ophthalmology at Olive View Medical Center in Los Angeles. He can be reached at jsridhar119@gmail.com.
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