Have you been wondering what is an index fund and how do I invest in one? If so, I’m glad because index fund investing is one of the simplest paths to create wealth.
When I began my quest to learn the basics of investing and saving money for retirement I spent countless hours reading and listening to various podcasts.
During the process, I learned a whole lot of good information. I learned about investing concepts that were quite complex and to be honest beyond me.
But what I really wanted to know is how I could invest in index funds?
Low-cost index funds are like the popular kid in school these days. Yes, all the cool kids are doing it. Are you in?
If you’ve already started investing you may have your money in stocks, bonds or my favorite money making asset index funds. Index funds are growing in popularity for good reason.
They are low cost, pretty darn secure and can produce the same returns as the market.
Obviously, there is a lot of excitement that comes with owning popular stocks like Apple or Facebook. However, some people aren’t interested in trying their luck at becoming the next millionaire by picking their own stocks.
Index funds are a perfect way for someone to invest in the stock market while steering clear of the nitty-gritty of stocks.
A downside of owning stocks is they require a significant chunk of time and the management costs can be quite steep. This is the reason why I’m such a fan of index funds. You don’t have to be a superstar to manage these investment funds.
WHAT IS AN INDEX FUND?
An index fund is a type of mutual fund which is basically a basket full of investments aka a portfolio. These portfolios are created to match or mimic other market indexes. For example, an S&P 500 index fund buys all the stocks in the S&P 500 index.
WHY SHOULD YOU INVEST IN A INDEX FUND?
The first reason why I like index funds is because of their simplicity. Mutual funds are made up of a combination of different investments like stocks and bonds.
They’re affordable, well diversified and tend to generate solid returns over time. Index funds are known for outperforming actively managed funds from top investment firms.
In 2007 Warren Buffet made a $1 million bet that a boring, low-cost stock index fund you could outperform most hedge funds over the past decade. Guess what, he was right… he won!
WHO’S JACK BOGLE AND WHY ARE INDEX FUNDS POPULAR?
Index funds were made popular by John (Jack) Bogle. Bogle founded Vanguard back in 1974, which is one of the world’s largest and most respected companies in the investment world.
Jack was the very first person to offer index funds to the public as a cost-effective way to begin investing.
You’re probably thinking ok, so what? What’s the rationale behind these so-called amazing index funds? Well, let’s start off with Jack Bogle’s reasoning for why index funds are so kick ass during his speech at “The World Money Show” back in 2005:
“Most people think they can find managers who can outperform, but most people are wrong. I will say that 85 percent to 90 percent of managers fail to match their benchmarks. Because managers have fees and incur transaction costs, you know that in the aggregate they are deleting the value. The investment business is a giant scam.“
Check that out! The guy who started Vanguard is saying that investment businesses are a giant scam!
Only 10-15% of managers are actually meeting their benchmarks. Basically, Bogle’s saying it’s these professionals full-time job to understand the market and invest our money. However, they are constantly falling short of beating the market!
This is the exact the reason I’m such a fan of index funds. If the so-called pros aren’t able to pick the right investments to out perform the market how the heck could I ever do so myself?
WHAT’S THE DIFFERENCE BETWEEN INDEX FUNDS AND MUTUAL FUNDS?
So let’s cut to the chase by saying an index fund is basically a mutual fund.
The biggest difference between the two is the cost! Doesn’t everything always come back to costs!
It sure does! The reason it comes back to money is that more often than not mutual funds are actively managed, where as index funds are not. Actively managed mutual funds require someone behind the scenes managing your fund and calling the shots. Which costs you money!
Of course, if your money manager does a good job you can make a lot of money however this also comes with fees. These fees are in the form of transaction or management costs to pay the people who picked your investments.
Index funds are what you call passively managed, there’s no one behind the scenes determining which investments to buy and sell because index funds are created to track an index.
You may be wondering how do index funds work and how does it track an index? The objective behind index funds is to mirror the performance of an underlying benchmark index such as the S&P 500. So when the S&P goes up and down so does the S&P index mutual fund. Make sense? I hope so.
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BENEFITS OF INDEX FUND INVESTING
The key to investing is diversification. When you have a diversified portfolio it decreases the chances you’ll lose your money.
Index funds offer the diversification you’re looking for!
For instance, an index fund that tracks the S&P 500 has 500 different investments. Talk about diversified, that’s a lot of investments!
Another benefit is that as the performance of funds fluctuate over time you won’t feel the volatility of the market, because your money is spread out among many assets.
2. Low Costs
Because index funds are passively managed and require very little manpower they remain low cost.
The managers essentially follow a recipe laid out by the index requiring minimal work to be done. It goes something like this… 3 parts of Apple brandy (Apple stock haha) and one part Facebook.
The manager follows the recipe laid out and buys the 3 stocks of apple and 1 stock of Facebook. Pretty simple right?
The manager doesn’t have to scrutinize over buying selling and selecting investments.
3. Solid Returns
Because many index funds mirror specific higher performing indexes with low operating costs you can expect to receive solid returns.
The annual expenses of actively managed mutual funds average several times greater than the expenses of index funds.
As Buffett knew when he made his $1 million bet, not even the best portfolio managers can make an actively managed mutual fund beat index funds:
Only 23.51% of actively managed mutual funds outperform the S&P 500 over five years, according to the latest date from Standard & Poor’s, and other studies have supported this.
Index funds have generally high returns and low costs, which make them an excellent value for investors trying to keep expenses low and profits high, which should be everyone.
WHAT ARE THE DISADVANTAGES OF INDEX FUND INVESTING?
As with any kind of investing there is always a risk. Market risk means that the market (as a whole) may go up or down at anytime. These are the waves you ride for the long haul to grow your your wealth. Longevity of your money in the market is the game.
HOW DO YOU INVEST IN AN INDEX FUND?
1.Compare. Take some time to compare online brokerages to check for fees and functionality.
2. Decide where you want to buy: Select a company that charges low fees and offers a range of index funds and ETFs. You can purchase an index fund directly from a mutual fund company or a brokerage.
3. Pick an index: Index funds track various indexes as explained above. One of the most popular is the Standard and Poor’s 500 index.
4. Check investment minimums and costs. Before you throw your money into an index fund be sure to check the costs and minimums. Some indices require an investment minimum of $1,000 or more. Obviously, if you don’t have this kind of money this isn’t an option for you to waste your time exploring.
Investing in Index Funds Summary
I hope this article provided you a bit of knowledge so you’re more comfortable when it comes to investing in your future. The takeaway you should remember when investing is:
Forget about trying to time the market rather focus on TIME IN THE MARKET.