Updated: Oct 1, 2020
This post is for anyone who has ever thought "investing is too risky for me" and for those of us who have been burned by individual stocks. Index funds are ideal for anyone interested in long-term investing and for people who want to be immensely wealthy in the future (with little work required). And don't just take it from me, Warren Buffett is also strongly in favor of index funds: "By periodically investing in an index fund, the know-nothing investor can actually out-perform most investment professionals". Yeah, that's right, Warren and I think the same.
What Is an Index Fund?
An index fund is a mutual fund that mimics/tracks a specific market index. Let's break that down, because I know that for many of you that was gibberish.
You may have heard of the S&P 500, an index that tracks the stock performance of the top 500 companies in the U.S. One index fund that tracks the S&P 500 trades under the ticker symbol "SPY" and has holdings in each of those top companies. Therefore, when you invest in "SPY", you are investing in a piece of every top 500 company in the U.S. The reason why I am such a fan of index funds that mimic the market is that with one investment, you can create a diversified, high-yielding portfolio.
Are you saying I'm not America's next top trader?
Yes, that's exactly right. I'm not, you're not, and your friend who bought 1 TSLA share at 350 and sold at 450 is not either. I am not doubting your intelligence but think about it. You are most likely still in school or starting out in the workforce. You do not spend 100+ hours a week analyzing stocks like the guys on Wall Street. (And the funny part is, even they usually can't beat the market: Twice a year, the S&P Dow Jones Indices releases the SPIVA US scorecard which tells us how well financial managers performed relative to the regular stock market. Here's what they consistently find - "Whether you look at the past 3, 5, 10, or 15 years, only about 15% of all professional mutual fund managers were able to beat the market". (The Simple Dollar)). With this in mind, why would you even try to pick individual stocks? You are competing with guys who do this full-time and large companies with a lot more resources than you. If you can't beat 'em, (and you can't), then join 'em and invest in funds like the SPY that mimic the market as a whole.
But isn't that boring?
Does 8% average yearly returns sound boring to you? Yeah, me too, but check out this calculator: https://www.investor.gov/financial-tools-calculators/calculators/compound-interest-calculator
If you start with just $100 for an initial investment and add $100/month for the next 40 years, at an 8% interest rate you'll turn $48,000 of invested capital into $315,000 dollars. Now that's a relatively small investment and many of you can probably do much more than that. Play around with the calculator to figure out the type of returns you may be able to realize over the long-term.
Now there are a couple of things to note here:
- The 8% return rate. I want to make it clear that you should not expect 8% returns every single year, but rather as an average over the long-term. I am not pulling that number out of my ass, the real historic return rate of the U.S. stock market has hovered around 8%. You will have years where the markets drop 10%, 20%, or even 50%, but you should expect wild upswings as well that lead to that average expected return.
- Long-term investing. This is the only way you can expect to see huge upside returns. You and I have the biggest advantage in the stock market right now: Time. We have many years to invest our money in the markets, allowing compound interest to create a snowball effect with our invested capital. Therefore, you must be playing the long game. If you are looking for a quick buck, find a side hustle. You need to be willing to ride out the markets’ swings and dips, and just let your money sit and work for you as you add to it.
- $100/month. This is some bullshit number I came up with because with the right dedication I think most people should be able to accomplish this. It is by no means a restriction, you can invest way more than this if you want. Just be smart with it, you should not invest anything that you may need in the next 6 months to a year. You have to plan out your expected expenses and have a rainy day fund.
How do I invest in Index Funds?
While I would love to be sponsored by The Vanguard Group, I am not, but I am a huge fan of their services. You should be able to use most major investment brokerages to invest in index funds, however, I like Vanguard because they offer many types of accounts with some of the lowest fees in the industry. It’s nice to be able to have most of your long-term and retirement accounts in one place to keep track of everything. I opened up a Vanguard Roth IRA account to invest in my index funds. Vanguard offers a variety, including the Vanguard Total Stock Market Index Fund (VTSAX) with a .04% expense ratio, and the Vanguard 500 index Fund (VOO) with a .03% expense ratio. Both of these work just fine, and closely follow the track of the S&P 500. So how do you actually invest? Just go to their website: https://investor.vanguard.com/corporate-portal/ and follow their links. You will need some bank account and personal information ready, but the whole process to set up the accounts will not take long. It may take a few weeks to have some forms submitted if you are transferring certain accounts from another brokerage, but for the low fees, it’s worth it.
PLEASE do not use a financial advisor to invest in index funds:
I fully believe that most financial advisors/managers are good people and want what is best for their customers, but for anyone reading this blog, I promise you can do what I am describing on your own. You do not need to pay someone else even a 1% fee (which actually can cost you hundreds of thousands of dollars over a lifetime) for a job that takes a couple of hours of setup and research in its entirety.
Index Funds for the Future
Index funds are the key to success in a world of market volatility. You need to have the will power to not fall for the headlines when markets crash, and instead add more to your position. When you invest in a fund that represents a stock exchange as a whole, you are investing in the future of the United States's top companies, and unless the world is coming to an end, it is a relatively safe way to immensely increase your wealth over your lifetime. Do not listen to your buddy who wants you to unload your savings into some individual stock he found on r/WallStreetBets, and instead invest your money in a broad, diversified market that has been rewarding investors for decades.