“Invest in index funds that give you exposure to the broad market of the best companies in the world and hold on to them for the long term.”Warren Buffett
When Warren Buffett gives advice, I listen. This is the advice he gives to individual investors. Individual investors like you and me.
“Invest in stocks. For instance, the S&P 500 or other indexes for further diversification in this basket.”Ray Dalio
If you haven’t heard of Ray Dalio. Google his name and you will soon realize that he’s one of the best investors in the world. He knows what he’s talking about and when he does, I listen.
So what are index funds and how do they work?
Let’s get right into it.
What’s an index fund?
An index fund is an investment fund that mirrors the performance of a market index.
Have you heard of the S&P 500 or Dow 30? These are market indexes. There are hundreds of market indexes. Not all market indexes track stocks (like the S&P 500 and Dow 30). Market indexes also track other assets like; bonds, commodities, and currencies.
You can’t buy market indexes so the next best thing is to invest in index funds because they perform as the market index does.
For example, if you want to invest in an index fund that performs like the S&P 500. You would buy an index fund that buys the 500 shares included in the S&P 500. If the mix of companies in the S&P 500 change, so does your index fund. You don’t make the change your servicer does.
Remember that an index fund mirrors the performance of a market index so if the market index is down, your index fund also goes down. For example:
Difference between index funds and eTFS
There are two types of index funds.
- Index Mutual Funds – an index mutual fund is what I explained above, it mirrors a market index. If the word mutual fund throws you off. Let me explain. An index fund is a type of mutual fund. A mutual fund alone doesn’t track a market index. Assets in a mutual fund are constantly changing, managers are buying and selling trying to beat the market.
- Index Exchange Traded Funds (ETFs) – the only difference between an index mutual fund (or just index fund) and ETF is that an ETF can be traded like a stock. It can be bought and sold multiple times a day. An index fund can only be traded once a day. If you don’t plan on trading your index fund (which for a beginner investor, I don’t recommend) go with an index fund.
benefits of index funds
Instead of investing in just one asset (stocks, bonds, currencies, etc.), you invest in many. It’s never a good idea to put all your eggs in one basket. Or in this case, all your money in one asset.
When you invest in an index fund you are diversifying your investments and choosing to invest in multiple assets.
Unless you and I decide to become financial analysts full time. We simply are not educated enough to pick stocks individually.
You can do your best to research a stock and read the annual reports but outside factors (competitors, politics, weather, prices, etc.) are simply out of your control. The last thing you want to do is put all your money in one stock (or even 5) and lose everything.
2. LOW FEES
The expense ratio (or fee) of an index fund is less than 1%. One of the most popular, index funds, the VFIAX that mirrors the S&P 500 has an expense ratio of 0.04%.
An index fund has really low fees because it’s passively managed. Passively managed means that managers are not actively trading assets in the fund. They are not doing research and constantly buying and selling. Remember that an index fund mirrors a market index and a market index tracks specific assets that rarely change.
How does an index fund expense ratio compare to a traditional mutual fund? The average expense ratio of a mutual fund is 2.5%. Sometimes you see lower expense ratios for traditional mutual funds but beware of hidden fees.
Maybe you think an expense ratio of 2.5% is not a lot. What if it cost you $86,000? That 2.5% is suddenly really high!
Here’s an example of what happens to a $100,000 investment with a yearly contribution of $1,000. The return for both funds is 7% but the expense ratio is different. The expense ratio for the index fund is 0.05%, for the mutual fund it’s 2.5%. Here’s your return after 15 years:
Look at the last two numbers on both lines. One is $301,000 and the other is only $215,000. That’s how much money you would have at the end of 15 years.
If you choose a mutual fund with a 2.5% expense ratio, your return would be $86,000 less.
Expense ratios are very important. Don’t be fooled when someone sells you a mutual fund with a 2.5% expense ratio. Now you know how expensive that is in the long run.
3. better than ACTIVELY MANAGED FUNDS
In the line chart above, the red line is a traditional mutual fund. A traditional mutual fund is an actively managed fund. They have higher expense ratios because managers are doing more work.
They are constantly buying and selling assets in hopes of beating the market.
So maybe you’re thinking the expense ratio is worth it and in the end, your return (or profit) is better because it’s being managed by professionals.
Well, here are the facts. Index funds perform better than mutual funds over 90% of the time.
This means that 90% of the time if you decided to invest in a mutual fund, you are losing money. And it’s not just a few thousand it’s hundreds of thousands of dollars over the course of your investment.
It’s very difficult or extremely expensive to find a fund manager that consistently beats the market. And remember that your index fund simply tracks the market, a specific market index.
Yes, the market goes up and down but in the long run, if you hold your investment for 10, 15, 30 years. You will see a profit.
4. YOU HAVE OPTIONS
The great thing about index funds is that you have options. Lot’s of options.
If you want to invest in the entire stock market or just a sector of the stock market, you can. If you want to invest in just bonds you have the option to do that as well.
I talked about diversification as the #1 benefit of index funds. As I said, instead of buying just one stock you can buy many that are part of one index fund.
It’s also a good idea to diversify your index funds. And because you have options, it’s easy to do.
The right mix will depend on what you’re interested in or what your Registered Investment Advisor recommends. Reach out and get the best advice for your investment portfolio.
5. investor of many with one transaction
The last benefit? It’s a real time saver. I’m going to use the S&P 500 market index as an example again. Say you want to mirror the performance of the S&P 500. Do you want to make 500 separate transactions or just one? I’m guessing you answered one.
When you invest in an index fund, you make one transaction and are invested in multiple assets automatically.
So much better right?
where to buy index funds
You can buy index funds at Vanguard, Fidelity, Charles Schwab, among others.
Vanguard, Fidelity, and Charles Schwab have different expense ratios and investment minimums so you’ll have to do your research.
Some index funds require you to invest a minimum of $3,000. Others require a minimum investment of $500. If you don’t have $3,000 or don’t feel comfortable investing $500. You can buy ETFs (Index Exchange Trade Funds) are a lot more economical. At Vanguard, ETFs range from $50 to $350 each. This is not a set price because as markets change, the price goes up and/or down.
If you’re new to investing and index funds, I recommend starting with Vanguard. Jack Bogle, the founder of Vanguard, created the first index funds so I trust the reputation of the company.
But don’t just listen to my opinion. Learn what others have to say about Vanguard and their index funds. Overall, you’ll see the feedback is great.
If you want to invest in an index fund but are a little overwhelmed with getting started. Find a Registered Investment Advisor (RIA) and seek their professional advice. Don’t forget to mention your interest in investing in index funds!
index fund summary
- An index fund is an investment fund that mirrors the performance of a market index.
- S&P 500, Dow 30, Russell 2000, S&P 500® Bond Index, are all examples of market indexes.
- You can’t buy market indexes so the next best thing is to buy index funds that mirror market indexes.
- Index funds have very low expense ratios (or fees), less than 1%. The best and most popular index funds have expense ratios of less 0.05%.
- Index funds give you the freedom of diversification. Aka, not putting all your eggs in one basket.
- In the long run, your index fund will grow as the market always does.
- The market has consistently outperformed (done better) than other assets like bonds. Bonds are another type of investment.
Learn from the greatest investors in the world. Warren Buffett, Ray Dalio, and Jack Bogle. Their advice to individual investors like you and me is to invest in index funds. Do your research (as you’re doing) and take action!