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After clearing my debts and getting my finances in shape, I was ready to start investing. Every piece of advice I found pointed me towards index funds, so I gave them a shot. Turns out, they’re a fantastic tool with numerous benefits for both beginners and experienced investors.
What Exactly is an Index Fund?
You’ve likely encountered the term fund when discussing investments. There’s a technical, formal definition, but in simple terms, a fund is just a collection of smaller investments bundled into one package. These investments might include major companies like Google, Apple, or Microsoft, or they could be government bonds. In essence, a fund is one large investment made up of smaller assets. It’s similar to buying an entire album of your favorite artists instead of purchasing each song separately.
An index fund is a fund that tracks a specific index, which is simply a gauge of a financial market. For instance, you’ve probably heard of the S&P 500. This index tracks 500 of the most influential companies in the United States. Trying to buy and sell stock in each of those companies individually would be a hassle, and researching your own picks could be even worse. Who has the time for that? Index funds take care of all the hard work for you—just buy one investment. If the index performs well, so does the index fund. If it drops, the fund follows suit. This is why they’re so popular: all the research and stock picking is handled for you.
There are numerous indices, and here are some of the most popular ones. Companies like Vanguard, Fidelity, and Charles Schwab have created various index funds for these indices and beyond. Here are a few examples:
When the S&P rises, Vanguard’s VFINX typically follows suit. If the S&P takes a dive, so will VFINX. This pattern holds for every index and its corresponding fund. Historically, the S&P has averaged a 10% return (before inflation) each year, so it’s no surprise that VFINX mirrors this return.
Why Index Funds Are Perfect for Long-Term Investments
Index funds come with several advantages that make them ideal for long-term investing:
Wide diversification
Steady, reliable performance
Low management fees
These benefits are essential to creating a reliable “set and forget” investment strategy.
Diversification
Diversification is critical when it comes to investing. You’ve probably heard the phrase, “don’t put all your eggs in one basket.” In financial terms, this means: don’t invest all your money into a single company, asset, or asset class.
For instance, Google is a strong, dependable investment. However, you wouldn’t want to invest every penny you have into Google. No matter how secure the company seems now, relying solely on Google for your retirement savings is risky. If something unexpected happens—like the company decides to pour all its funds into reviving Google+—you’d probably start to worry. The bottom line: if something goes wrong, you lose everything, and you’re left with nothing.
On the flip side, if you’ve spread your investments across other assets as well, you’re still protected if Google’s stock drops. That’s the essence of diversification, and that’s exactly how index funds operate. They spread your money across hundreds or even thousands of different assets, whether it’s company stocks or government bonds. To sum it up: index funds come with built-in diversification. The financial institutions that create the index carefully select companies with diversification as a key focus.
Consistent and Streamlined Performance
With an index fund, you’re essentially placing a straightforward bet on a consistent index, like the S&P 500. While the index does experience fluctuations, historically, it’s delivered a 6-7% return after inflation. That’s a solid rate for long-term goals, especially retirement savings.
Here’s how J.D. Roth explains it on Get Rich Slowly:
Do index funds consistently outperform each year? Not necessarily. In fact, they’re often somewhere in the middle. By their very nature, index funds mirror the market average — neither outperforming nor underperforming.
However, over the long haul — ten, twenty, or even thirty years — something remarkable occurs. Index funds rise to the top. It turns out that average short-term returns actually result in above-average long-term performance.
In essence, index funds are designed to be stable and uneventful. They won’t make you an overnight millionaire, but realistically, nothing will, and they’re a reliable choice in the long run.
Affordable Fees
In other types of funds, a manager or investor selects and monitors individual investments. They keep a close watch on them, buying and selling based on performance, aiming to outperform the average 6-7% return through active management. This strategy is called active investing, and it comes with a price.
When you invest in a fund, you’re charged an expense ratio, which covers the costs of running the fund. With active investing, the expense ratio is typically higher because of the additional effort involved in managing your investments.
In contrast, because index funds simply track an index, they don’t need much upkeep. If the index performs well, your index fund follows suit; if the index declines, your fund will too. This is what we call “set and forget” investing, or passive investing, which involves little to no maintenance and results in much lower fees.
This Morningstar study discovered that, over time, index funds tend to outperform actively managed funds. Active investors often challenge these findings, but one thing remains clear: index funds generally come with lower costs than actively managed funds, and this can significantly impact your returns over time. While active funds may occasionally outperform the market, they come with higher costs. Sometimes that extra cost is justified, but with index funds, you know exactly what you're getting: low fees.
Now, here’s the catch: most index funds require a fairly high initial investment, usually between $3,000 and $10,000. It’s a significant amount, I get it. But keep in mind, you’re investing in thousands of assets at once, and that requires capital. If you’re not quite there yet in terms of savings, you’ll need to build up your investment account until you reach that minimum. Once you do, it’s time to start selecting and purchasing your fund.
How to Choose the Right Index Fund
Before selecting your index fund, it’s essential to determine your asset allocation, so you can choose the right index to invest in. You’ll also need an investment account, like an Individual Retirement Account (IRA) at a brokerage firm to actually buy the fund.
A well-diversified investment portfolio strikes a balance between two main asset categories: stocks and bonds. We’ve explained how to determine your asset allocation in detail, but ultimately, it’s based on your risk tolerance and how long until you’ll need access to the funds (usually, this refers to retirement). As a general guideline:
110 - your age = the portion of your portfolio that should be allocated to stocks
That’s just scratching the surface, though. To purchase your index funds, you’ll need to determine which specific asset classes to invest in, such as international stocks or U.S. bonds. Tools like Personal Capital’s portfolio checkup or Bankrate’s Asset Allocation calculator can assist you in figuring this out. For instance, according to Personal Capital, here’s my ideal asset allocation:
Once you have your asset allocation figured out, selecting your index fund becomes much simpler. You’ll just need to find funds that fit within the asset classes you’ve chosen. (If that seems like a hassle, you can always opt for a lazy portfolio with pre-selected fund recommendations.) Here’s how the process works.
First, check the “Asset Class” section in the example above. This will show you the broad asset categories you need to focus on: International Stocks, US Stocks, International Bonds, and so on. Let’s narrow it down and choose index funds for US Stocks.
To find index funds for this category, I’ll need to search for them at my brokerage firm. I use Vanguard, and here’s their list of stock funds. From there, I can easily search for the specific index fund(s) that belong to the US Stocks category. Here’s what I found:
There are several types of indices within this category, such as large-cap, small-cap, and others. As you gain more experience with investing, you’ll likely refine your portfolio to include more specific subcategories. However, for now, sticking to the basics is a great way to get started. In my case, I chose the index funds VTSAX and VFIAX. Once I had those in mind, I took a look at a few key details.
First, ensure that the expense ratio is as low as possible. This is one of the key advantages of index funds. According to the Motley Fool, a typical index fund has an expense ratio around 0.25%. As you can see from the example above, one of these funds has an impressively low rate of just 0.10%. Vanguard, in particular, is known for its minimal fees.
Additionally, check that the fund truly tracks its corresponding index. Compare the fund’s performance history with that of the index it’s supposed to mirror. The two should align closely. For instance, here’s a comparison of how VFIAX performs relative to the S&P 500:
Once you’ve selected and vetted your fund, it’s time to make the purchase. Log into your investment account, select “buy,” and input the necessary details. You’ll likely need to specify the source of the funds (whether from your bank or another investment account) and the index fund you wish to purchase. Alternatively, you can always call your brokerage to place the order and tell them how much of each fund you want to buy.
Index funds provide an excellent, low-maintenance way to build your investment portfolio. Yes, you’ll need to rebalance it occasionally, and it does require some initial capital, but overall, it’s a form of investing that’s relatively hands-off. While there will be ups and downs, with time, you’ll watch your investments grow into a nice, well-earned nest egg.
Artwork by Fruzsina Kuhári.
