NEW YORK (CNN/Money) -
I don't have the time or knowledge to pick and manage my investments, and I don't want to pay someone to do that for me. Would putting my money in index funds be the best move for a person in my position?
-- Tony Beck, Dallas, Texas
Not only do I think index funds -- essentially, portfolios that track a benchmark or index rather than try to beat it as actively managed funds do -- would be an excellent choice for someone in your position, I think they'd also be an excellent choice for all those investors out there who think they know a lot about picking stocks and mutual funds but in reality don't know half as much as they think they know.
In fact, I think this second group might benefit even more from index funds since their overconfidence can lead them to make costly gaffes.
Why an index fund?
Okay, so why am I such a fan of index funds? Well, for one thing they're cheap. Expense ratios for stock mutual funds average about 1.4 percent of assets a year. Most index funds charge less than half that amount, and some charge as little as 0.18 percent. Lower expenses mean you get to keep more of the fund's return.
And since index funds buy and hold the securities of the benchmark they're tracking rather than frenetically buy and sell securities like most funds, they tend to be more tax efficient -- that is, they generate fewer taxable distributions, which raises your after-tax rate of return.
It doesn't hurt that over long periods they tend to outperform the majority of actively managed funds, largely the result of their lower fees and transaction costs.
Oh, and I also like them because they make life simple. I don't know about you, but I've got a life beyond my investment portfolio. If there's a way to invest that offers low costs and competitive returns and frees up for really important pursuits like spending time with my family and listening to Elvis tunes (Presley and Costello), I don't need much convincing to take advantage of it.
Don't fly totally on automatic
Remember, though, that going the index fund route doesn't totally free you from having to make decisions. There are funds out there that track dozens of different indexes, ranging from ones that follow the entire U.S. stock market like the Wilshire 5000 to ones that mirror only a small portion of the market, like the Russell 2000 index of small stocks or even specialized indexes of market sectors like retail or semiconductors. For some guidance on sifting through various index funds, click here.
And investing in indexes also doesn't absolve you from dealing with the most important aspect of investing -- namely, setting your asset allocation.
Indeed, the way you divvy up your portfolio among asset classes such as stocks, bonds and cash will likely have the biggest impact on how your portfolio performs. For guidance on this critical issue, I suggest you visit our Asset Allocation calculator.
One final note: as big a fan of index funds that I am, I'm not such a zealot that I don't think investors should ever own actively managed funds. I prefer index funds as core holdings, but actively managed funds can certainly play a valuable role in investors' portfolios as well. They just require a little more care and feeding.
Walter Updegrave is a senior editor at MONEY Magazine and is the author of "Investing for the Financially Challenged." He can be seen regularly Monday mornings at 7:40 am on CNNfn.