How and why beginning investors should invest in index funds
Are you a novice investor? Or one who hasn’t taken the plunge yet – not done any investing at all? Maybe you feel as if it’s too complicated. You could lose your money if you make the wrong decisions. Or, you’ve done some investing, and you sort of understand stocks and bonds and mutual funds. You’ve heard about index funds, but you don’t really know what they are, or why you should consider them. Whatever your starting point, index funds are an easy and fairly low-risk way for you to enter or go deeper into the exciting world of investing.
What are index funds?
An index fund is a mutual fund or exchange-traded fund (ETF) tied to a financial market index made up of stocks, bonds or securities. When you buy into an index fund, you own a piece of all of the elements in that index. For instance, if you invest in the Standard & Poor’s 500 Index (S&P 500), you will have approximately 500 of the biggest companies in the U.S. represented in your portfolio.
Index funds aren’t actively managed by financial professionals like other mutual funds are. They are simply matched to the performance of the index as a whole. In spite of this “hands off” approach, index funds often perform better than managed mutual funds.
The benefits of index funds
I am a big fan of index funds – especially for new or small investors. Here is why you should consider having one or more of them in your portfolio:
- They are low cost. You pay fewer fees to invest in them than you would with funds that are actively managed, because you’re not helping to pay the salary of that manager. The upshot: an index fund has what is known as a low expense ratio compared with other types of investments.
- They are fairly stable and low risk. Market indexes tend to increase in value over time. (The S&P 500 has averaged a ten percent return throughout its history up until 2020.1)
- Your chances of losing a lot of money on your investment are very low. Not nonexistent, but very low. Index funds are diversified, which means your risk is spread out among a lot of different holdings. For you to take, say, a total loss would mean that every single company in the index fund would have to fail and go bankrupt. That, of course, is highly unlikely. Keep in mind, though, that you may not “make a killing” with an index fund, as you could with a riskier, high-performing investment, like a stock. However, if that stock takes a turn for the worse, the profit you made on it could vanish pretty quickly.
- An index fund diversifies your portfolio.
- Index funds are easy to understand. Some investments are complex; you need to thoroughly analyze them in order to make the right choice about them. Index funds are simple and straight forward.
- Index funds don’t take up your time. If you want to get the best results with individual stocks, you or your broker will have to track their performance on an ongoing basis. Even if the composition of an index fund changes, the effect on the investor is minimal, if any. If a company leaves an index fund or gets removed from it, it will be replaced by another company – one whose stock you will then own without putting any time or effort into it.
Hmmm, you’re thinking. An index fund sounds like it might be a good fit for me because I prefer an investment that’s safe and accessible. But how, exactly, do I go about investing in one? Is there a minimum amount (and can I afford it)? Should I put in a lot of money all at once, or do I have to pay attention to timing? How do I know which type of index fund to choose?
These are good questions. Let’s take them one by one.
How do you invest in index funds?
The simplest way to buy into an index fund is to do so through a brokerage house – preferably a low-cost one. Fidelity, Vanguard or Schwab are good choices for U.S. citizens. CMC Markets, IG Group and Commsec are popular among Australians. In other countries, if you are unsure, simply try a Google search with something like “best brokers for buying index funds in India” for example.
Is there a minimum investment?
Some companies offer access to index funds with no minimum investment. Others may require you to invest from $1 to $3,000 or more. The company offering these funds will be able to provide that information up front.
How should you time your contributions?
“Timing” should not necessarily be a part of the equation. As with many types of investments, putting money into mutual funds should ideally be done through dollar cost averaging. This means that you contribute a set amount of money on a specific schedule. For many people, setting up an automatic transfer from their bank account to their brokerage house account every week or every month is the most efficient way to do that. Dollar cost averaging is a long-term strategy that frees you from the need to keep track of – and develop strategies to deal with – the market’s ups and downs. More experienced investors will often remind us that “Time in the market is much more important than timing the market”.
Whether you’re young or older, taking retirement needs into consideration is always a good idea. You can do this by choosing a target-date index fund that adjusts over time, becoming less risky and more conservative as you get closer to retirement age. Whether you’re a Gen Z or a Baby Boomer – or somewhere in between or beyond – having an index fund in your portfolio can help you grow your wealth in a low cost, low risk way.
What does the “World’s Greatest Investor” say about Index Investing?
Warren Buffett is an American investor, business tycoon, and philanthropist, who, at age 89, is still the highly active chairman and CEO of Berkshire Hathaway. He is often regarded as one of the most successful investors in the world and has a net worth of US$72.4 billion as of July 2020, making him the eighth wealthiest person in the world. In a 2013 letter to Berkshire Hathaway shareholders, Buffett described the instructions he included in his will for managing his wife’s trust. “My advice to the trustee could not be more simple: Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund. (I suggest Vanguard’s.) I believe the trust’s long-term results from this policy will be superior to those attained by most investors”.2
With Warren’s track record and vast experience, who could argue against that?
How do I figure out which index fund to buy?
There are literally thousands of index funds available for investors big and small. There are index funds made up of index funds. Don’t let the options make you feel overwhelmed. I obviously cannot provide specific advice on an exact fund to invest in but I would suggest, at a minimum, executing the following steps:
- Determine what you can easily afford as an upfront and ongoing investment
- Look for a fund that is low cost ongoing – an expense ratio under 0.15% is ideal
- Look at long term returns – a fund’s performance over 5 to 10 years. It will give you a better indication of how it will perform in the future (but remember, past performance is a guide only and is not reflective necessarily of future performance).
- Read the product disclosure statement (PDS) or equivalent (Prospectus). This contains important information, including:
- what assets the fund invests in
- the fees
- the risks of investing in the fund (compare against your own risk profile)
- the benchmark or target return
- how to complain if you have a problem
- Make an initial investment, say 50% of the upfront lump sum you have available
- Invest the rest over a set period (dollar cost averaging)
- Invest a portion into the fund on an ongoing but repeating basis, perhaps every two months, say (again, dollar cost averaging)
- Monitor performance (every 3 months).
As an example, after a little research, I have come across the Vanguard US Total Market Shares Index ETF (symbol VTS on the Australian stock exchange). A snapshot of the fact sheet taken from Vanguard site reveals the following:
- Management cost: 0.03% p.a.
- Minimum investment: No minimum
- Performance over 5 years: 12.35%
- Performance return over 10 years: 15.49%.
It is worth noting that using the ‘Rule of 72’ (a quick formula used to estimate the number of years required to double the invested money at a given annual rate of return), if we take the 10 year return rate of 15.49%, on average our investment would double roughly every five years.
Your PROFITABLE ACTION STEPS this time around:
- Based on the learnings above, do some of your own research via Google and/or consult your financial planner/adviser. Find an index fund that aligns to your risk profile and adheres to the checkpoints above, particularly regarding ongoing costs and past performance: 5-10 years. Take control of your own future.
- If you haven’t already, go to my home page and download my Passive Income Guide. It describes a number of ways to earn income with minimal ongoing effort (in most cases) and it’s ABSOLUTELY FREE.
Stay safe, healthy and wise and most importantly of all, take ACTION.