At 22 years old I started to get into investing and while doing my research and reading personal finance books I came across this beautiful thing called index funds.
Before we get into what an index fund is let’s see if they are right for you (which I’m sure it is).
If you are like 99% of people then you are just trying to make money in the stock market by being a passive investor.
While I’m sure you want money like Warren Buffet, Peter Lynch, or Ray Dalio, are you willing to put in years of study, research, and hard work? Most likely not.
Hey, some of you might want to, so go right ahead!
I recommend you learn more about investing by reading the amazing book, The Intelligent Investor by Benjamin Graham.
Most people just want to put their money in an investment and let it grow passively!
How awesome is making your money work for you and you barely have to pay attention to it?! This blows my mind!
Let me tell you right now that you won’t make $100 million dollars or more with index funds.
Matter of fact, you won’t make this much money in any type of stock unless you have a lot of money to put in as an initial investment and invest really early on.
By the time you get this money, you will probably be much older. In fact, Warren buffet made 90% of his fortune after 50.
So yes, getting rich in the stock market takes time.
Listen I know there are those people who are exceptions but this is the truth!
If you want to become a multimillionaire or billionaire (which is possible) then you need to start a business.
I spoke about this in-depth in my Fastest Ways To Get Rich post so if you want to start a business then check it out!
Okay now, let’s go more in-depth on what index funds are.
What Are Index Funds
To understand index funds you need to have a basic understanding of the stock market.
You only need a very basic level of understanding so stick with me.
I’m sure you heard about the Dow Jones, S&P 500, and NASDAQ at some point in your life but what are they?
They are stock indexes that are simply used to measure certain sections of the stock market. For example, the NASDAQ is used to measure mostly technology and biotech companies.
So what an index fund does is just match the index, simple.
It takes an index like the S&P 500 or the whole U.S stock market and then allows you to invest in all the companies in that index.
Let’s stick with the S&P 500 as our example for this post but just know that the performance of the S&P Index funds and total U.S index funds are very close, this is due to the market-weighted nature of most index funds.
According to NerdWallet, the S&P 500 has historically returned 10% annually. Now, of course, this doesn’t mean that it will continue to do so forever but it is a good indication of the return you will get.
Even though you get 10% of your money every year, you have to factor in inflation which is about 2% – 3% a year.
You will be really looking at a 7%- 8% annual return but this is much better than your .01% interest in your savings account!
Okay, this is a pretty good return but if I invested my money in Amazon a year ago my return would be 94%! (at the time of writing this)
Yes, you are totally right, index funds are not the holy grail when it comes to investing. There are individual stocks that are better choices and cherry-picked portfolios that perform better.
So why index funds?
Well, it’s really for safety, cheaper fees, and even performance. Let me explain.
Why Index funds
Let’s go over a little math to see why index funds are the bomb, so stick with me.
First, let’s go over your awesome investing skills. Like I said there are individual stocks that can outperform index funds greatly.
How will you know which stocks will perform better and for how long? This is key.
There are thousands of stocks in the U.S so how will you pick ones that will perform better than index funds? It’s easy to say “well Amazon and Apple are huge and they are the best companies so I will invest my money in those.”
In the past couple of years, you would be right and you would have made a killing! But how long will these companies keep performing like this and when do you get out before you start losing money?
When there is a strong bull market it is pretty easy to win by picking individual stocks but when the sky turns grey you are not going to be the “expert” stock picker like you once were.
Okay, enough of my little rant. Here is a fact, According to NerdWallet, Index funds outperformed actively managed mutual funds 90% of the time.
Two factors play a big part in this. One is that nobody can time the market, take it from Peter Lynch.
“Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves.”
Then there are the fees…
According to Investopedia, the average mutual fund has an expense ratio (just a fancy term for total fees) of around 1.3% – 1.5%.
The fee for the Vanguard S&P 500 index fund is only 0.14% and when you have at least $10,000 invested you are only charged 0.04%!
Vanguard now offers its admiral shares for just $3,000! So, you can invest in the VFIAX which charges only 0.04% for only $3,000.
Let’s do some math. Say you invest $10,000 in a mutual fund charging 1.3% then you’ll have to pay $130 in fees.
Not too bad right?
But, let’s say your investment grows to $100,000 now you have to pay $1,300 in fees!
Now for the same amount in index funds. Investing $10,000 at 0.04% only leads to a $4 fee and $100,000 only leads to a $40 fee!
This is awesome!
Just to let you know, you can buy Vanguard ETF’s which are basically mutual funds disguised as individual stocks.
You can get a low 0.04% fee without the minimum $3,000 investment.
But, there are two issues with ETFs…
One is that you can’t buy partial shares of an ETF, meaning that if the ETF costs $260.12 and you only have $200 to invest then you are out of luck. You have to wait until you have the full amount to invest.
The other big point is that at this point there is no way to automatically invest in ETFs as you can in mutual funds.
This is a big deal-breaker for me and it should be for you too because automatic investments are so important in your personal finance plan.
If you haven’t done so already, read The Automatic Millionaire by David Bach.
I have to mention that there are some downsides to investing in index funds.
I will talk about this in another post because this post will get too long.
Just know that index funds are overall really great investments.
Where To Invest
So now you know that index funds are great investments, where do you invest?
Well if you didn’t know by now, I am a big fan of Vanguard for index fund investing.
This is for a few reasons, the first is that Vanguard was the first broker to offer index funds.
Also, they have been around since 1975 so they are trustworthy.
Another great broker that I use is Fidelity.
For example, Fidelity’s S&P 500 index fund has no minimum needed to invest and the expense ratio is only 0.015%!
This is compared to Vanguard’s Admiral S&P 500 index fund which has a minimum of $3,000 to invest and has an expense ratio of 0.04%.
So, Fidelity is definitely worth a look!
Another great broker to look at is iShares which offers index funds for very low fees.
Note that the expense ratio is just the basic measurement of how much the fund will cost you.
Other factors include tracking errors, tax efficiency, turnover rate, etc…
Check out this article by MarketWatch for a better understanding of these factors.
Index funds are great additions to your investment portfolio!
Maybe they might be your whole investment portfolio and that is perfectly fine because of the diversification they provide!
Their low fees and passive nature are great for beginner investors!
If you are employed and are thinking about investing in your company’s 401k/403b then check out my Simple 401k and 403b Facts post!
Also, Vanguard and Fidelity let you open up IRA and Roth IRA accounts for your retirement planning. Check out my Simple IRA and Roth IRA Facts post on the benefits of an IRA account.
I have to mention that index funds are not all sunshine and rainbows. There are some downsides that you should know, and if you want to check these out, head over to my post on the problem with index funds.
Do you invest in index funds? If so, what broker do you use and why?