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Index Funds vs. Mutual Funds

Written By Brian Hicks

Posted March 30, 2015

Index funds don’t just outperform a majority of actively managed mutual funds, they also grant investors higher returns. And no, those aren’t the same thing.

The difference is between a fund’s total gain or loss and its return by the dollar. The total gain or loss is the standard performance measurement of which you can find the value listed on fund-company websites.

Combine share price changes and dividends to determine the number that will tell you how much you earned, assuming no shares were bought or sold after the beginning of the given period with the exception of reinvested dividends into additional shares.

The total dollar return reveals how much money the investor made rather than how much the investment made. Suppose that a fund ended the year where it began, for a 0% gain, but throughout the year its share price took off and eventually fell back to where it started.

If investors increased their investment in the given fund according to its initial movement, they would have lost money in the long run despite the fund’s 0% total change.

Low Risk, High Reward

Mutual fund investors have a habit of buying funds after strong performance and then rushing to sell in the ensuing downward trend.

But as a rule, they enter and exit stocks more patiently as well as see higher returns in the long run when they stick to index funds rather than siding with actively managed funds, which seek to beat the market.

An index fund contains all of the securities that make up a market index like the S&P 500. This is in an attempt to emulate the index’s upward trudge.

Time and time again, sticking with index funds, even through bear markets, has rewarded patient investors with inevitable gains.

Most actively managed funds fall short of indexes as the stocks that mutual funds are made of perform less consistently and carry with them fees that hinder investor returns.

Playing The Odds

A great deal of the recent data available on index funds versus mutual funds carries with it the migration from active funds to index funds during the 2007-09 bear market.

The influx of volume brought new life into indexes, and six years later, the rally has been kind to index funds’ reputations in terms of their returns by the dollar.

It’s tempting to argue that index funds investors have dispositions better suited to the trials of the stock market. They instinctively lean towards the funds with greater chances of success despite lesser returns and longer wait times. While managed funds possess the capabilities of providing bigger returns in a much shorter time frame, the odds of them actually doing so can be remote.

Warren Buffett, one of the most successful investors ever, has said that if you don’t want to stick with a stock for 10 years, then you shouldn’t buy it at all. Keep that in mind as you decide between indexes and mutual funds.