Investing as a beginner can be pretty overwhelming. There are so many things you could invest in, like real estate, stocks, or cryptocurrency. You do not know where to start.
One of the simplest ways to invest for your future is index investing. Index investing is using index funds to create your portfolio. We know that even the best investors talk about using a low-cost index fund approach is the best for ordinary people.
So, what is index investing, anyway?
What is Index Investing?
One of the greatest investors of all time, Warren Buffett, said, “By periodically investing in an index fund, the know-nothing investor can outperform most investment professionals.” Knowing what Buffett knows about investing, he knows that average regular investors can outperform most professionals by simple index investing.
Index investing creates a portfolio of index funds in a mutual fund or Exchange Traded Fund (ETF) that follows a specific index like the S&P 500. The index fund has the same securities held on an index, and therefore as the index goes up and down with the market, the fund will mirror it. It is a passive way of creating a portfolio.
The great thing about index investing is the passive nature and the low costs due to no active managers trying to beat the index. Therefore, from 0% to 0.5%, the expense ratios are lower. If you get higher than 0.5%, the cost is much higher.
Funds with Vanguard, Fidelity or Schwab are generally some of the lowest cost index funds on the market. Vanguard boasts VTSAX and VFIAX as its flagship index funds with an expense ratio of 0.04%. That is $4 for every $10,000 invested. Fidelity also has some zero-fee funds that bring the expense ratio to 0%.
These lower costs allow the average investor to create a simple portfolio that makes wealth. As the market goes up, the fund goes up as well. In 2021, the S&P 500 went up 26.8%, so those index funds that tracked the S&P 500 would also go up close to 26.8%.
How Did Index Investing Start?
Index Investing was started by John Bogle, the creator of Vanguard. He created his first index fund in 1976 to track the S&P 500 index. The index would have the top 500 companies in the United States.
They call this “Bogle's Folly” because banks felt that index funds would fail. They called the index fund “un-American.” It was bound to fail, but Bogle wanted to create something low-cost. A fund that average Americans could use to build wealth without charging an arm and leg to make money.
As a passive strategy, index investing took off to create Vanguard as one of the largest mutual fund producers in the world. These index funds that Vanguard continued to create did almost nothing during the markets of the late 70s. The raging bull market that ran from 1982 to March 2000 brought these stocks returning an average of roughly 18% annually. People owning these index funds were getting their fair share of the market, sparking the success of the index investing.
What Are the Benefits of Index Investing?
When you buy index funds, you get many benefits from them. One of the most important ones is the affordability factor of index investing. The low costs of a passive investing approach help the investor save money. Without constant trading, index investing comes with lower taxes. They are also widely more diversified than other portfolios. Typically, they will outperform most professionals in the long run.
It is Easy
Beginners can quickly start investing in the market right away. There is no need to do additional research on specific stocks and financial analysis. That time can be spent doing other things.
With individual stocks, you may be tempted to sell during the high volatility of the market, which can cause panic and stress. With the increased diversification of an index fund, one stock will not drop a fund to the massive depths of hell. There are many other stocks keeping it afloat.
Index funds are for you to buy and chill. It makes investing straightforward.
The Affordability of Index Investing
“When trillions of dollars are managed by Wall Streeters charging high fees, it will usually be the managers who reap outsized profits, not the client.” Warren Buffet mentioned this at his shareholder's meeting. “Both large and small investors should stick with low-cost index funds.”
You can save costs through
- Commission costs
- Expense ratios
- Lower taxes
The cost of dealing with stockbrokers and financial advisors advising managed funds can mean a ton of money to the client.
Low-cost index investing is all about passive management of funds. The funds are tracking an index, which means there are no extra costs associated with the index funds. Lower expense ratios keep you as the investor in a better situation.
Actively managed mutual funds have managers buying and selling different securities to try and beat the market. In the process, short-term capital gains taxes are passed on to the customer. With active managers, there are also higher expense ratios associated. The tax situation also brings about some extra costs.
As these tax costs and expense ratio fees accumulate, the passive index funds become more apparent as the winners because they make more money with lower prices. As Warren Buffett said, the companies that create actively managed funds are reaping many fees. They are also bringing about a larger tax bill for the investor. If you want to save money, it is best to go with something that is a low-cost index fund. It saves on fees and taxes.
Index Investing Brings About Diversification
Index investing brings about a lot of diversification to your portfolio. With this diversification comes less risk. If one stock underperforms, it may not be a deciding factor that destroys your portfolio. Instead, you will have less risk associated with many other stocks. As new stocks begin to rise, they will show more of an impact on your portfolio.
People often say, “don't put all of your eggs into one basket.” As we think of index investing, we must think about having a large basket of eggs. The Vanguard Total Stock Market index fund VTSAX holds around 4,000 different stocks of companies on the U.S. stock market. If one of those stocks fails, then 3,999 others are there to support the fund.
Less risk brings on less stress. Of course, investing does come with risks and drawbacks, and even though diversification is excellent, index funds could have some drawbacks.
It is a Proven Strategy.
Index funds are often compared to actively managed funds. The debate over which one is the best continues. Since index funds are passively managed, they track or mirror the underlying index. The actively managed funds try to outperform the index or the market through buying and selling different securities. These methods can lead to potentially higher costs to the investors.
According to CNBC, “Only 11% of actively managed large-cap funds outperformed their passive peers over ten years.” As you look at these numbers, how are you supposed to choose the top 11% over the last ten years? It is nearly impossible. Over the last 50 (1972-2021) years, the S&P 500 has averaged an 11.17% return, adjusted for inflation would be closer to 7%. Those numbers are hard to beat.
It is a safer bet to go with a proven investment strategy with a passive index fund than to outperform that same market.
What Are Some of the Major Drawbacks of Index Investing?
Index investing is not always the best for each individual. Some investors may prefer to go with their stock pickings or even a professional manager to help them with the ups and downs of the market. So people may like real estate more.
The index fund will go up and down with the market. As a bear market comes in, the prices may fall, but the prices will also gain as the market rises.
Lack of Professional Portfolio Manager
A professional portfolio manager is someone that helps manage your money. These people will buy and sell securities to help alleviate any losses or even go bigger into other sectors.
The index fund is more straightforward. You buy it, and you hold it. That is about it. The index fund will never beat the market; it mirrors the stock market index and gives you returns based on how the market does.
Those that want to beat the market will want to hire someone to help them do that. With the hiring of professionals, there will be costs involved to make great returns.
No Individual Stock Ownership
When investing with index funds, you own a pile of stocks tracked by the index. They are usually weighted, but indexes like the Dow Jones Industrial Index track companies by stock price, making them slightly different.
There is no opportunity to own more of a particular stock. If you want to own a ton of Apple, Microsoft, and Tesla, you would have to buy those shares. Index funds are not giving you most of how you want to design your portfolio. That can be a significant drawback for confident investors.
That is also the beauty of index investing. You no longer have to do much research about individual stocks. You buy and hold the fund.
How Do You Start to Invest in Index Funds?
Let's explain how to start to invest in index funds in a simple 3 step process. The process will help you in determining the best fit for you.
- Pick an index
- Select a fund
- Purchase shares
Pick An Index
There are many different indexes you can choose from as you are determining what the best index for you is. The most popular in the U.S.A is the S&P 500. It holds the top 500 companies in the U.S. market, and it has a significant diversification and great returns over the years.
There are numerous other indexes you can choose from that are pretty popular. Here is a small list of some of the major indexes.
- Large Cap stocks: S&P 500, Dow Jones Industrial, Nasdaq Composite
- Small-Cap Stocks: Russell 2000
- International Stocks: MSCI EAFE, MSCI Emerging Markets
- Bonds: Bloomberg U.S. Aggregate Bond Index
After these major indexes, you can find more sector-specific indexes such as semiconductors. There are indexes so many other types of markets that can be country-specific or even industry-specific. When choosing what you want to invest in, pick an index and find a fund that tracks that index.
Select a Fund
Once you have selected the index you would like to invest in, it is time to find the fund that you can buy. Finding the right fund has a couple of things to consider
- Expense ratios
- Investment Minimums
- How close it is to the index
- Does the brokerage company have other funds to choose from?
As you are looking for a good fund, it is good to look at the low costs of the funds. Different funds have different expense ratios. There can be an investment minimum to invest in certain index funds. Another thing to look at is how closely the fund matches the index. The closer the performance, the better it will perform.
Lastly, look at funds at a brokerage company that you are looking at buying other funds. If you are looking at many Vanguard funds, it may be best to go with Vanguard.
Now it is time to purchase your fund shares. In the recent past, commission and trade costs have come down, allowing buying shares much easier.
Buying fractional shares of index ETFs has become the norm in many brokerage companies like Fidelity and Schwab. With new investment apps like Robinhood and M1 Finance, you can buy more fractional shares and build your portfolio.
It is time to find where you want to buy index funds and start investing.
Here are 7 of the Best Index Funds
Index funds come in all sizes and shapes. Many companies create some of the best index funds like Vanguard, Fidelity, Blackrock, Schwab, and Investco. Here are 7 of the best index funds you can choose from.
- Vanguard Total Stock Market Index Fund (VTSAX)
- Vanguard 500 Index Fund (VFIAX)
- Fidelity Large Cap Zero Fund (FNILX)
- Vanguard Real Estate Index Fund ETF (VNQ)
- Vanguard International Index Fund (VXUS)
- Investco QQQ Trust
- Schwab US Dividend Equity ETF (SCHD)
Who Should do Index Investing?
Index investing is best for almost anyone. It is easy to do, affordable has various allocations, and is a proven strategy. Along with these factors, index funds are significant for these types of investors:
If you are a beginner investor, investing in individual stocks is not recommended. There is a significant learning curve, and you will need to spend quite a bit of time learning the ins and outs of each company you seek to invest in.
Index funds give you the ability to start investing now. There is little research; you can automate your investments and continue without much effort.
With so many commitments and other opportunities taking our time from us, investing may take a backseat. Index funds become the perfect investment vehicle for the passive investor.
You can set it and forget it. All you need to do is choose the right fund for you and automate it. It can be that easy.
Perhaps, you have started to learn more about investing. You could be in that category between beginner and expert. Index funds are a great way to have a solid base for investing. You can have a majority of your portfolio in index funds and dabble with individual stock investments on the side.
The days of much safer investments giving good returns have come and gone. Many vehicles are out there for people, but retirees can get the best bang for their buck with low-cost index funds. There is no need for a financial advisor to take a 1% chunk out of the portfolio. It can be self-managed with index funds giving a generous 7% annually.
As people read about personal finance, they become curious about how to invest better, where to start, and what would be an excellent long-term investment strategy for themselves. Index investing comes with a lower risk tolerance and low fees that help people begin their journey into investments.
As you learn about investing, you can start by funding your IRA or Roth IRA by creating index funds that help you create a passively managed portfolio. You can add more index funds and some individual stocks with a brokerage account.
Index investing gives the investor a great way to create wealth without much work. You choose the index, select a fund, and buy the shares. You allow the market to do its thing and continue to invest in the index funds. It is a simple way to create a portfolio that will win at the end of the day.
Please keep it simple, invest with index funds. If the best investor in the world recommends it, it can't be too bad. As Warren Buffett said, “Both large and small investors should stick with low-cost index funds.”
Steve Cummings is the founder of the personal finance blog The Frugal Expat. As a traveler and expat, he has learned a lot about how to save money, live frugally, and invest for the future. His mission is to help people in saving, investing, and reaching financial independence.