Index Funds vs. Mutual Funds

Your financial advisor is going to give you choices in your 401k or in your IRA between index funds and mutual funds. What are the best choices to make when it comes to your retirement? What is the difference between index funds and mutual funds?

The Difference Between Index Funds and Mutual Funds

A lot of mutual funds charge fees of up to 2%, no matter how good the fund is doing. They could be losing your money and they would still charge you fees, whereas index funds theoretically don't charge very much in fees. Let's talk a little bit about those choices between the two.

Mutual funds tend to have higher fees than index funds but, mutual funds basically do the same thing that an index does.  That means that they are both diversifying your portfolio across hundreds of stocks.

An index fund still diversifies you, but it tracks a very specific index.

For example, you could buy the Fidelity Magellan mutual fund, which is essentially a shadow of the broad market S&P 500. You could also buy SPY which is the index fund that tracks the S&P 500 exactly.

Why Not Just Invest in Index Funds or Mutual Funds?

The first reason is that you probably don't have enough time.

Index funds or mutual funds are great if you:

• Have a lot of time before you need your money.

• Are putting in a lot of money into the account so it can add up.

Unfortunately, there are a lot of baby boomers out there that have no chance of a market rate of return that will allow them to retire comfortably. The returns just aren't good enough. That's a major problem with index and mutual funds.

The Problem With Exchange Traded Funds

The other thing you need to know about certain index funds, which are often called "exchange traded funds" or "ETFs", is that they might become illiquid if fear starts to build up in the index that it's tracking.

You can move in and out of an ETF easily like a stock unless the price starts to drop significantly.

Bond-related ETFs own very illiquid bonds underneath a liquid ETF. It's an index tracking bond indexes, but if the ETF starts to drop, it could quickly become something you can't sell at any kind of a price.

There are great investors like Carl Icahn, warning about the dangers of some ETFs damaging small investors and becoming the next big lever to crash this market and create another financial panic.

If you want to be a passive investor, then go ahead and do it. If you're not willing to learn how to invest, you're going to have to go with whatever you can get and track the market at best.

If you'd like to see how you stack up against experienced investors, take my Investing IQ Quiz!