Investing the Simple Way With Index Funds

The basics on personal finance are simple. Spend less than you earn and invest the difference.

The “spend less than you earn” half is critical, but in most cases not sufficient for building wealth. To truly get ahead, you need your money to start making money on your behalf.

There are many ways of investing, but investing in the stock market has the advantage of being nearly entirely passive. Especially if you use index funds. This lets you focus your time and energy somewhere else as your money tirelessly works for you in the background.

In this post, well break down what an index fund is, starting with defining stocks and mutual funds. We’ll talk about some of the reasons why index funds are such a powerful investment. We’ll go over some of my favorite index funds. And we’ll look at some index funds that expose you to different asset classes besides stocks.

Let’s get started.

What is a stock?

A stock is just an ownership stake in a business. If a company has 100,000 shares of stock outstanding and you own 5,000 of them, you own 5% of that business.

As the part-owner, you are entitled to receiving a share of the profits that the business earns should it pay a dividend. This is one of two primary ways that you can make money with stocks.

The other way is to sell your shares to someone else. If the shares are worth more than what you paid, you’ll have made a profit. What determines how much a share is worth? Whatever someone is willing to pay for it. In the short term, this means that prices can fluctuate irrationally. In the long term, the price tends to rise or fall based on the success of the business. Everyone knows Amazon is more valuable today than it was in 1999.

So far so good, but there are a couple of issues that might be jumping out at you.

The first is that I said that investing in stocks is nearly entirely passive. But now I’m saying investing means buying shares of companies and you might have questions like:

  • How do I know which companies to invest in?
  • What kind of research do I need to do before investing in one?
  • Will I have to keep up with what is going on with the company and the industry?

The other issue concerns risk. Obviously you shouldn’t put all your eggs in one basket. You can’t invest safely in just one company, you’ll need to spread your money out over lots of companies. Where are you going to get the money to even get started? It must be expensive to buy shares of tons of different companies.

We need a better system than buying stocks ourselves. That brings us to the nest level: Mutual Funds.

What is a mutual fund?

The idea behind a mutual fund is that it allows investors to pool their money to diversify their investments across many different stocks.

So a brokerage like Fidelity creates a fund, you and I and some other people throw some money into it, and we have joint ownership of the fund. Instead of directly owning shares of stocks, we own shares of a fund that uses our investment capital to buy and sell stocks.

Of course, when I say “the fund” buys and sells stocks, there’s actually a fund manager and potentially a team of researchers that are actually doing the buying and selling.

The mutual fund solves a lot of problems. You no longer need to worry about doing the research because someone else is doing it for you. You no longer need to worry about diversifying into different companies because someone else is taking care of that. And you no longer need to worry about having enough money to diversify, because a bunch of people are pooling their money together.

Mutual funds sound pretty great right? What could possibly be the issue?

Well, there are two issues:

  • Risk
  • Cost

The risk of underperforming

The big risk of mutual funds is that your fund will perform poorly. Maybe the stock market as a whole will return 7% this year and your fund will only manage 5%. Maybe your fund actually loses money.

This is somewhat offset by the fact that there’s a chance that you’ll actually beat the market in any given year, but it’s vanishingly rare for a fund to beat the market year after year. It’s so rare, that funds that were able to do it for a significant stretch—like the Fidelity Magellan fund—became famous.

Of course, the Fidelity Magellan fund eventually stopped beating the market and came crashing down to Earth. In fact, as Jack Bogle points out in The Little Book of Common Sense Investing, most of the people who invested in the Magellan fund probably did worse than the market as a whole.

How is this possible when the fund outperformed the market for so long? Simple. The Magellan fund’s outstanding performance is what attracted investors. The bulk of people who invested missed the early phenomenal returns, and got on board just in time for reversion to the mean to kick in.

They made the classic investing mistake of buying high and selling low.

It seems like it would be so easy to pick winning funds, but it isn’t. Most of this years winners are about to come crashing back down. Some of this years losers will turn things around, but many won’t. It’s possible to jump from winning fund to winning fund just like it’s possible to flip “tails” ten times in a row. I wouldn’t bet on it.

The cost of active investing

You have to pay to invest in a mutual fund. It doesn’t seem like it, because they’ll never send you an invoice or charge your credit card.

The main way that you pay is something called the fund’s expense ratio. This is the how the investment company recoups the cost of operating the fund and tries to make a profit. This money just silently leaves your portfolio without you ever knowing.

There can be other fees that you are charged as well, such as load fees and sales commissions.

The problem with fees is that every penny you pay to the investment firm is a penny that will no longer compound for you over time. This means that your losses become exponential. I wrote a whole post about how high investment costs can erode your portfolio:

In order to maximize your returns, you want to minimize your fees.

Unfortunately, most actively managed mutual funds are going to come with high fees. The active trading of stocks incurs significant cost, and the hot shot investor and his team of researchers don’t come for free. These costs are passed on to you either in the form of lower returns or higher fees.

Investment fees are relentless. You will be charged if you make money. You will be charged if you lose money. Your returns are never guaranteed, but your costs are.

When picking a fund, you want as low of an expense ratio as possible. You also want to make sure their are no load fees, transaction fees, or basically any other fees of any kind.

What is an index fund?

Instead of buying into a fund where a managers buys and sells stocks hoping to beat the return of the S&P 500, what if you just bought the S&P 500?

What exactly is the S&P 500 anyway?

The S&P 500 is an example of a stock market index. It’s a way of tracking the market as a whole. In the case of the S&P 500, it looks at about 500 of the largest companies in America. The value of the index is weighted by how large each company is. So Apple and Amazon affect the index as a whole more than Advance Auto Parts.

You can also have a total stock market index that includes basically every publicly traded company in America.

Index funds attempt to recreate the composition of an index. So if Apple makes up 6% of the S&P 500, an index fund tracking the S&P will try to put 6% of it’s money into Apple.

Technically, index funds are a sub-set of mutual funds. You’re still putting your money into a large pot with other investors and you own a share of the fund. But instead of an “actively managed” fund where someone is buying stocks they think will go up and selling ones they think will go down, index funds are “passively managed” by a set of rules that call for them to match the composition of the market (or market sector) they track.

Index funds are a powerful way to counter the weaknesses of traditional mutual funds:

Index funds provide a guaranteed market rate of return

There’s no chance that you’ll underperform the market, because you’re buying a slice of the market as a whole. As long as your index fund is able to faithfully track it’s index, you are guaranteed a share of the market’s return.

You lose the chance of beating the market, but you also lose the chance of losing to the market.

Index funds come at low cost

Some people say that to keep costs low, you should be looking for an expense ratio of 0.5% or less. Forget that, Because stock market index funds come at such low costs, I tell people to look for 0.05% or less. That’s a staggering 10x difference from the traditional advice.

Examples of actual index funds

Vanguard Total Stock Market Index Fund – Admiral Shares (VTSAX)

Vanguard is the investment firm started by Jack Bogle in 1975. It’s not a publicly traded company, or even a privately traded company. The ownership model is unique: The company is owned by the funds which are owned by the investors. Usually, the owners and investors are at odds. Owners want higher profits, and therefore, higher fees. Investors want lower fees. Vanguard’s model is a clever way around this conflict of interest.

This means that you can expect Vanguard to offer rock-bottom fees. Instead of trying to make a profit off of you, they are simply trying to recoup their costs.

Of course, as we’ll see, other firms can beat Vanguard on price on individual funds, but in general Vanguard is rightfully considered a low cost leader.

You’ll often see me reference this fund on this site. I basically consider it to be the standard against which other funds are measured.

That said, there are a couple of funds out there that stack up pretty well. VTSAX is a great investment option, but it comes with a minimum investment of $3,000 and an expense ratio of 0.04%, which can both be beaten.

Schwab Total Stock Market Index Fund (SWTSX)

The Charles Schwab Corporation is a publicly traded company. Unlike Vanguard, they are looking to earn a profit for someone besides their owners.

That said, SWTSX slightly undercuts VTSAX on cost, with an expense ratio of 0.03% compared to VTSAX’s 0.04%.

Because Schwab is trying to make a profit, it’s likely that they are using SWTSX as a “loss leader.” This is a sales strategy where you sell a product at a loss to get a customer’s foot in the door, then make your profit by selling them products with a higher margin.

The thing about loss leaders is that they usually go away. Either they stop attracting new customers, or management realizes that the customers that come aren’t buying anything else.

While I don’t know for sure if the low expense ratio will last forever, I do know that it is currently lower than Vanguards. SWTSX also has a minimum investment of just one dollar. This is important, because I don’t like barriers to new investors getting started.

I’ve actually invested in this fund and have no major issues with it so far.

Fidelity ZERO Total Market Index Fund (FZROX)

Fidelity is a privately owned company based in Boston, Massachusetts. This means that unlike Vanguard, they are looking to make a profit off of you. Like Schwab, it’s likely that any low-cost offering is actually a “loss leader” designed to just get you into the door.

But FZROX did something unprecedented. It offered an expense ratio of 0.0%. That’s right, no expenses or fees whatsoever.

It also has no investment minimums.

I’m not going to lie, both of those features are pretty impressive. Their also great for investors.

I actually have money in FZROX and have no complaints.

How to pick an index fund

To get started investing in stocks, you can open a brokerage account at a company like Vanguard or Fidelity or Schwab. You can open a retirement account like an IRA or Roth IRA to save on taxes, or you can just open a regular account if you’re not eligible for retirement accounts or have hit the contribution limits.

You can pick a total stock market index fund, or an S&P 500 fund. The S&P 500 makes ups about 80% of the value of the stock market, and the two have performed similarly historically. Chances are that during the period of time that you invest, one will slightly outperform the other, but there’s no way of knowing which one will be the winner. In any case, it will be the difference between an A and an A+, not an A and an F.

Look for options with a low expense ratio (below 0.05%) and no other fees.

Some funds will have investment minimums, which you’ll have to take into account. Although as we’ve seen, there are options that let you get started with any amount.

What about your 401k?

One of the best places to get started investing is your 401k at work. The primary reason is that most companies will match some portion of your contributions up to a certain limit. For instance, my company matches my contributions dollar-for-dollar up to 6% of my salary. If you aren’t investing enough to get the full employer match, you’ve essentially given yourself a pay cut.

The problem with 401k’s is that you have to choose from a menu of investment options provided by your employer, and it’s probable that most of them are bad.

Instead of looking at past performance like the rest of your co-workers, be on the lookout for key terms:

  • Total stock market
  • S&P 500
  • 500
  • Index

Look for index funds that track the S&P 500 or total stock market, have a low expense ratio, and don’t carry any other fees.

Right now, most of my money is invested in a fund I haven’t mentioned yet: The Fidelity 500 index fund (FXAIX). Did I do exhaustive research and determine that this is the world’s best index fund? No. In fact, I think the expense ratio of 0.15% is way too high. I invest in FXAIX because it’s the best fund my employer offers.

If your employer literally has no acceptable options, you can complain to HR and tell them you’d like to see low-cost index funds offered like those from Vanguard.

You can also stop investing in your 401k after hitting your employer match and instead invest in an IRA with a company and a fund that you choose.

Index funds aren’t just for stocks

The stock market is a powerful tool for building wealth. It exposes you to the creativity and productivity of American businesses.

The problem is that it can be a bumpy ride. Some years the market might return 20% or even 40%, some years it might lose 38%. These ups and downs don’t mean much when you’re putting money into the market, but they start mattering quite a bit when you are taking money out.

The way that you protect yourself is by diversifying away from just stocks. I wrote a very long, very helpful post about this:

Some off the asset classes that you might diversity in to include bonds and REITs (real estate investment trusts). fortunately, there are index funds that allow you to invest in these asset classes just as easily as you can invest in stocks.

For instance, you can invest in bonds with Vanguard’s Total Bond Market Index fund, VBLTX.

If the total bond market is too broad for you and you want to invest in a particular sector like intermediate term treasury notes, you can do that with a fund like VFITX

Final Thoughts

Index funds are simple and effective. For most people, they are the best bet for grabbing a share of the returns of the stock market at the lowest possible cost.

I invest in index funds, and I recommend that others invest in index funds. I feel confident recommending index funds to anyone who asks, because on the off-chance you’re not the kind of person who should be investing in index funds, you’re probably not asking for investment advice anyway.

For the vast majority of people, index funds save time and make money. That’s what I’d call a good investment.

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