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Playing with professionals does not have to be a losing battle, but learning the techniques and believing in your abilities can be a great challenge.
Yesterday, I entered the ring with a professional and survived to tell the story. It was on the tennis court -- the ring where you can usually find me when I'm not learning how to become a better investor -- and I was playing singles in a top women's league. When I met my opponent, I was stunned. She was the teaching pro at the club where the match was being played. Not only was she a "professional," but she was 20 years my junior and fit as a fiddle. (I tend to be fit as a tuba.) How could I survive a match against a player who had mastered all the techniques I was still paying a small fortune to her colleagues to learn?
I had only one hope. Hit the ball back. Since she clearly had more tools at her disposal, my only hope was to keep the points alive while letting her shoot for the winners. Sure, she could win lots of points by being successful with her high-risk hit-winner-after-winner strategy. But I've learned through investing that the more risks you take, the higher the potential to lose.
Investing in index funds is a lot like "hitting the ball back" for individual investors. An index fund is a mutual fund that keeps a portfolio of securities designed to match the performance of the market as a whole. Since you're not trying to beat the market, you're minimizing your risk by not constantly shooting for that big winner. The market is represented by an index such as the Standard & Poor's 500, which has risen an average of 13.6% annually over the past 50 years. Contrast this with managed mutual funds, which have returned only 11.8% during that same time period.
If you read Step 4 of our "13 Steps to Investing Foolishly," you'll learn that this differential of 1.8% makes a HUGE difference over the long term. During the past 50 years, $10,000 put into the average managed mutual fund would have returned $2.59 million. BUT, if you had put that same $10,000 into an S&P Index fund, it would now be more than twice as much -- $5.78 million! This is due to the power of compounding over time, and the destructive power of mutual fund fees that erode your returns year after year. (A 1% annual fee on a $2000 account is only 20 bucks, but a 1% fee on a $5 million account is $50,000 -- for the same service.)
Recently, a new type of index investment has hit the market. It all started with the S&P Depository Receipts (SPDRs -- a.k.a. Spiders), which represent a single unit of ownership in an S&P Depository Receipt <% if gsSubBrand = "aolsnapshot" then Response.Write("(AMEX: SPY)") else Response.Write("(AMEX: SPY)") end if %>. The great thing about Spiders is that they can be bought and sold like individual shares of stock, and they trade on the American Stock Exchange. As the SPDR trust is a pool of money managed to mimic the Standard & Poor's 500 Composite Stock Price Index, the price of a unit in the trust is always the current value of the S&P 500 divided by 10. Remember, however, that you will have to pay commissions each time you buy or sell, and there's an annual management fee (currently around 0.18%, similar to Vanguard's 500 Index fund).
Hot on the heals of Spiders came the Dow Diamond <% if gsSubBrand = "aolsnapshot" then Response.Write("(AMEX: DIA)") else Response.Write("(AMEX: DIA)") end if %>, which allows investors to buy or sell shares in a portfolio of Dow Jones Industrial Average stocks, and the Nasdaq-100 <% if gsSubBrand = "aolsnapshot" then Response.Write("(AMEX: QQQ)") else Response.Write("(AMEX: QQQ)") end if %>, whose index represents 100 of Nasdaq's largest companies across major industry groups, including computer hardware and software, telecommunications, retail/wholesale trade, and biotechnology.
So there I was on the court, the little index fund versus the high-flying tech stock. I stuck to my philosophy -- just hit the ball back, don't risk going for the big ones, keep your losses to a minimum -- and I was astonished as my opponent made error after error trying to make the big return. I beat the "pro" in straight sets, 6-4, 6-1.
All wasn't lost for her, however. She was on the court with a Fool. After the match, we talked about investing. She confided that she really wanted to invest for her future, but was reticent about beginning. In addition, she only had a small amount to contribute each month. I gave her my Foolish calling card, and recommended she learn about Drip investing.
She may have lost the match, but she's gained an investing portfolio.