Index funds are all the rage in the investment world. You hear about how the index fund is the way most people should be investing. And you know what? That is 100% right! The index fund is the best way to get in on the market action, while limiting your risk. But what is an index fund? Let’s start with the basics.
What is an Index Fund?
Per Investopedia.com, an index fund is a type of fund with a portfolio constructed to match or track the components of a financial market index, such as the Standard & Poor’s 500 Index (S&P 500).
Essentially, if you decide to invest in an S&P 500 Index Fund, you will receive returns at essentially the same rate as the market, with a small reduction due to investment fees.
How does and Index Fund do that? Simply by buying shares of the same companies that the index has and at the same rate. So if the S&P 500 includes 5% of Microsoft, then the index fund will also have roughly 5% of Microsoft.
This also guarantees one big asset when it comes to investing: diversification. When buying an index, you are buying shares in all of the underlying companies. Therefore, you are instantly diversifying across that asset class. Something that is hard to do by picking a few individual stocks to invest in.
History of the Index Fund
Back in 1975, John Bogle, founder of investment giant Vanguard, invented the first Index Fund. While he was derided by many of his competitors, John Bogle opened the door for millions of normal people around the world to finally get in on the investment game. The game which at that point was ruled by the wealthy.
Fast forward to today and Index Funds are a huge player in the investment market. Thanks to their built in diversification and low fees, they are the go-to investment vehicle for many individual investors looking to hold for the long-term.
How to Get In on the Action
If you want to start investing into Index Funds, the first thing you need to do is pick who you will use to hold the funds. I personally use Vanguard as they have a fantastic offering of index funds to choose from and competitive fees.
Once you open an account and deposit some money, all you need to do is to purchase some index funds. This choice is up to you and your risk tolerance. There are many different funds to choose from which focus on many different industries. My advice would be to get a book, like Tony Robbins’ Money: Master the Game and learn all about different ways to diversify your risk. This book changed my investing life and how we diversify our investments. Thanks to Tony Robbins’ book, our investments have gained roughly 6.5% since the beginning of the Coronavirus Pandemic. Far better than the return on the S&P 500 (-7.3%).
Why Invest in Index Funds?
Index funds are all about 3 things: Simplicity, Diversification, and Low-Cost. Let’s discuss each one further.
Simplicity
Index funds are simple to invest in. All you need to do is pick the ones you want in on and then put your money in them. Once you make your investment, you are pretty much set. All you need to do now is sit back, relax, and enjoy the ride!
Diversification
As discussed up above, the index fund is designed to track a market index. These indexes are typically made up of many investment holdings. By tracking these indexes, index funds are, by definition, well diversified throughout their asset class. The only area of diversification you need to be concerned with is asset class diversification which can be easily rectified with investing in 2 or 3 different index funds which focus on different asset classes, such as 1 that tracks the S&P 500 and another Long-term Treasury Bonds.
Low-Cost
Where the index fund really excels is the minimal fees of many funds. For a very low cost, you get access to a fund which tracks the market. There is no need to use high cost mutual funds which have no guarantee their returns will match the market. Once you consider fees, the decision is a no-brainer. Let’s look at an example of how fees can affect your portfolio.
Here is the scenario:
- Invest $1,000 per month
- Over 30 years
- Assume 7% rate of return for both Mutual Fund and Index Fund
- Mutual Fund expense ratio = 1%
- Index Fund expense ratio = 0.04%
This example is a clear case of compounding working against the mutual fund. Thanks to the higher fees paid, the mutual fund will have $1,138,215 after 30 years. That is significantly less than the index fund at $1,365,175. A full $226,960 less! That’s over 16.5%! That 1% expense ratio is just an average of mutual funds. Some funds are much higher. Think about all those lost earnings!
Index Funds: The Few Downfalls
I would be remiss without discussing some downfalls of the almighty index fund. While there aren’t many, they should be considered when deciding the best investment strategy for you.
Due to the nature of the index fund, you don’t have the ability to pick and choose stocks that you want to hold. Investing in an index fund that tracks the S&P 500 will give you all the stocks in that index. But what if you don’t want some of them or want a higher percentage of lets say Microsoft? That’s just too bad. Not going to happen when you invest in the index fund.
Investing in just 1 index will give you a lack of protection against downturns in that asset class. Just investing in the S&P 500 index fund will get you all the returns of the market, both positive and negative. Of course, you can fight against this by investing in index funds throughout multiple asset classes they perform different in different market situations.
The Conclusion on Index Fund Investing
Even though there are downsides to index fund investing, I believe them to be minimal. Especially for the personal investor. The index fund gives you the opportunity to track the market as efficiently as possible, for minimal cost. This is not an opportunity you should pass up! By passively investing in index funds, you can set your deposits automatically and let compounding work its magic. You just need to sit back, relax, and enjoy your life. Come back years later, and see what the magic has brought you!
Additional Reading on Index Funds
There is a lot more to learn on index funds than discussed above. If you would like to know more about the funds and the different types, give “Index Fund Investing 101: The Beginners Guide to Index Fund Investing” a read. That E-Book will teach you everything you need to know regarding index fund investing and what comes along with it.