Investing in index funds is not settling for less

Score one for the little guys — or, in this case, the average investor.

Two things have happened since July that have shown you don't need a ton of cash or access to a hedge fund manager to make big bucks in your retirement plans.

All you need is the ability to buy index funds, which almost everyone can do if they're enrolled in a 401(k) or have an IRA. Index funds are a mix of investments set up to mimic a financial market (e.g., the S&P 500), and they typically don't cost very much because they're not actively managed.

I have index funds in my IRAs through Vanguard. The fees are very reasonable.

The first — and most important — thing that happened is that Eugene F. Fama and Lars Peterson of the University of Chicago and Robert J. Shiller of Yale University won the Nobel Prize in Economics for their research that looked at a basic question: Can you time the market? They found that, over the short term, the answer is no.

"There is no way to predict the price of stocks and bonds over the next days or weeks," wrote the Royal Swedish Academy of Sciences in its announcement awarding the trio the prize. "But it is quite possible to foresee the broad course of these prices over longer periods, such as the next three to five years."

That's what index funds do — over that and much longer periods of time.

Popular index funds

These funds all have annual expenses well below the maximum 1% we recommend.

Fund Ticker
Vanguard Total Stock Market Index VTSMX 0.17% 21.17% 10.62%
Vanguard Total International Stock Index Fund VGTSX 0.22% 9.75% 5.85%
Vanguard 500 Index VFINX 0.17% 13.74% 6.91%
Fidelity Spartan Total Market Index FSTMX 0.10% 21.17% 10.59%
Year-to-date and 5-year average returns ending Sept. 29, 2013

The award came three months after Bloomberg Businessweek published a scathing cover story called "The Hedge Fund Myth" with a not-so-subtle illustration about how machismo can play a role in hedge funds, about how the real people getting rich on those investments are the people collecting investors' fees, and that even though hedge fund managers have fancy degrees and big salaries and banks of data at their fingertips, they also can't beat the market.

"According to a report by Goldman Sachs released in May, hedge fund performance lagged the Standard & Poor’s 500-stock index by approximately 10 percentage points this year, although most fund managers still charged enormous fees in exchange for access to their brilliance," Businessweek wrote. "As of the end of June, hedge funds had gained just 1.4 percent for 2013 and have fallen behind the MSCI All Country World Index for five of the past seven years, according to data compiled by Bloomberg."

According to the article, most hedge funds charge a fee of 2% of assets. And that's if you're even "lucky" enough to have enough cash to invest, or are invited, to be part of the fund. That's a lot to pay for poor performance.

My Vanguard funds have earned 8% to 10% a year over five years, and I haven't had to do a thing to keep them growing — just pick the fund and let it go.

The investing game can seem rigged, but what this Nobel Prize and that article have shown us is that we don't need to be business whizzes to invest smartly. In fact, it probably works in our favor that we don't think we're smart enough to beat the market.

Index funds don't sound sexy or exciting, but they don't need to be if they help our nest eggs grow. And that's what really counts.

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