SHOULD YOU PILE INTO AN INDEX FUND?

This "Financial Focus" column is prepared by Edward Jones Investments, headquartered in St. Louis. Jones includes branches throughout the nation, including Cape Girardeau and Jackson.

Stock picking used to be an individual affair. Investors picked their stocks one at a time and monitored the progress of each. Then came stock mutual funds, and investors were able to rely on the pros to choose a group of stocks and stand and watch over their performance.

Most recently, millions of Americans have invested in stock index mutual funds. These "index funds" hold shares in all of the companies that make up a popular stock market index, for example, the Standard & Poor's 500 index. The fund's performance is tied to how the index performs.

Index funds are known as "passively managed" funds because they simply track the daily price movements of the index stocks and adjust holdings accordingly. They are the autopilot brethren of "actively managed" funds (also known as "managed funds"), which employ top-flight managers to analyze market outlooks and industry trends, then trade accordingly.

Individual investors have plowed millions of dollars into S&P 500 index funds over the past few years, mostly through their 401(k) programs. What's the attraction? It's the results: The S&P 500 index beat most actively managed mutual funds over the past 10 years.

Some of the success of index funds can be attributed to expenses -- or lack thereof. Managed funds have higher costs because fund managers actively buy and sell stocks, and are compensated for their decision-making. These annual expenses are figured into results. Index funds, on the other hand, spend less. Lower expenses mean more money for the shareholders.

So, shouldn't we all sink our savings into an index fund? The answer is no, for a few reasons.

Some investors believe index funds are a safer option because, while they do no better than the market average, they also guarantee that they will do no worse. This sounds like they present less risk, but what happens when the stock market goes down? An index fund falls with the market, perhaps even more so.

While long-term investors should ride out market falls, index funds violate the rule of investing designed to minimize risk in a downturn: diversify, diversify, diversify. The S&P 500 index is perceived by many as "the market," but it is actually much less diversified than you think. It accounts for 68 percent of the overall U.S. market capitalization, but it contains less than 5 percent of the actual number of stocks listed on the various U.S. stock exchanges.

In other words, rather than being diversified, your savings are tied to the fortunes of a handful of huge companies. Managed funds, on the other hand, own a broad range of companies.

Indexing also supposes that a certain segment of the market, such as large-cap companies, will lead the parade. But what happens if U.S. small-company shares or foreign stocks outshine the blue chips over the next decade? Market cycles make diversification important.

Although index funds have their positive points, there are good reasons to avoid passive investing. When markets are unsettled, as they are today, mutual fund investors might do better to look for broad diversification, courtesy of actively managed funds.

The Southeast Missourian does not recommend that readers buy or sell stocks featured in this column, which is provided for informational purposes only.