Financial Tip Friday: Invest in Index Funds

Financial Tip Friday: Invest in Index Funds

In a couple of different posts I have recommended that people need to start investing immediately.  The first place to start would be your employer’s retirement plan. Unfortunately, there are many employers who don’t have one. If that is the case with you then you can easily open up an IRA or Roth IRA at any of the major brokerage firms like Fidelity, Schwab, Vanguard (you can do it online) and begin your investing journey.

However, once you start the next question is where do you put your money? How do you invest? Investing can be really intimidating for some people. They don’t know what a mutual fund is or the differences between large cap, mid-cap, small cap, stock fund, bond fund, balanced fund, etc.

Like any new subject, however, once you know the vocabulary it isn’t that difficult to navigate the language of personal finance. That said, it can still be intimidating for people. So much so that people would rather put their money under their mattress or in a savings account where they will literally LOSE money instead of taking an opportunity to invest.

My simple solution for this dilemma? Answer: INDEX FUNDS! Index funds are fantastic investments because they have a very low cost and are fairly easy to understand.

What Is An Index Fund?

An index fund is a mutual fund that basically tracks a specific index. For example, one index fund that is very popular is the Vanguard S&P 500 Index fund. In essence, that index fund tracks the S&P 500. So if you buy this Vanguard fund (VFINX) you are essentially buying the ENTIRE S&P 500. Therefore, you don’t have to worry about picking specific stocks or get into a debate about asset allocation or whatever. You just basically buy a large index so you get instant diversification.

Advantages of an Index Fund

There are a number of advantages of an index fund over actively managed mutual funds. The first advantage has to be the low-cost. Depending on what kind of index fund you own your fees are typically super low. For example, I own the Fidelity Spartan Total Index Fund. The fees for this fund are .05%. That is SUPER, SUPER cheap. Considering that the average fee is around 1 to 1.5% of your portfolio you are saving a TON of money by buying an index fund. I think I read in one study that over the lifetime of your portfolio that high fee mutual funds can cost the average investor upwards of $30,000 or more, depending on how much money is in your portfolio. That is a HUGE chunk of change. Index funds don’t cost that much and your cost in minimal compared to other funds.

A second advantage of some mutual funds is INSTANT diversification and asset allocation. You have heard the old saying that you never put all your eggs in one basket. The same is true for investing. You never put all your money in one specific stock or whatever. However, when you buy an index fund you get instant diversification because you are buying an entire index, a whole boatload of companies.

Now there are different index funds. For example, in my 401a I don’t have access to an index fund where I can buy the entire stock market. I do OWN index funds in that account. But I have to spread my risk around by buying a combination of index funds and an actively managed fund, which cost me a bit more money. If I did have access to a mutual fund where I can buy the entire market I would PUT ALL of my money into that fund because of instant diversification and asset allocation. I am buying the entire stock market, not just one sector, so I get built in protection.

Third, most people can’t pick the right stocks. I think I am a pretty savvy investor, but I fully admit I don’t have the knowledge or time to investigate individual stocks. Index funds provides that for me. So I can own Apple, Google, Starbucks, whatever by just buying an index fund. Most people are looking for that get rich quick scheme. The truth is there is no such thing. The tortoise still wins the race. That is why index funds are the way to go. They are the slow, steady pace that if you do it overtime I believe you will be successful. If you want a great primer go to Jim Collins blog and read his stock series. It is FANTASTIC! Jim is not a financial professional, but has done very well in index fund investing, but lays out a whole host of articles on investing that would be great for people.

Fourth, Warren Buffett says so. There is a reason why Warren Buffett is called the Oracle of Omaha. He is a great stock picker, but he is only one man. And Buffett has said that when he dies he recommends that his foundation put his money in an index fund and watch it grow. Mr. Buffett even told Lebron James to invest in index funds. If it is good enough for the Oracle it is good enough for me. I don’t think Mr. Buffett is exactly stupid with his money.

What Kind of Index Fund Should You Buy?

According to some people, there is an playful art to index fund investing. If you ever have a chance go over to the Boglehead Forums and just read some of their ideas on index fund investing (they are called Bogleheads because they believe strongly in the philosophy of Jack Bogle who started Vanguard and index fund investing). Starting off, however, I would invest in an index fund that buys the entire market. Because my accounts are with Fidelity I own the Fidelity Total Spartan Index Fund.  It is a good one and essentially mirrors other index funds like it. The most popular (and I would buy it if I could in my 401a) is the Vanguard Total Stock Market Index Fund. It is extremely popular with good reason.

Once you have some more money in your account I would then buy something like the Vanguard Total Bond Index Fund. A bond index fund isn’t as sexy as stocks, but it will provide some nice balance to your portfolio.

The Bottom Line

Investing can be really intimidating. The key is to begin NOW. Don’t wait. Even if it is $100 a month you would be surprised how quickly that money grows over time. Stick that $100 in an index fund, leave it alone, and keep adding to it and watch your investments grow.

Like with anything, however, don’t take my word for it. DO YOUR OWN RESEARCH! But index funding is the primary way I invest with some slight modifications and eventually I will move everything to index funds.

2 thoughts on “Financial Tip Friday: Invest in Index Funds

  1. Agreed. My financial advisor (aka my brother) has always had me invest in Index Funds. You can’t go wrong with the S&P 500.

  2. You are so right. I think the Vanguard S&P 500 or the Fidelity Spartan is pretty good. There are certainly others, but those are the ones that are some of the most popular and do the best.

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