It’s hard to pick stocks. I’ve been investing in the stock market for decades and learned a while ago that I’m not a stock picker. Even professional investors struggle to regularly outperform the market. Sure they have some good years, but overall beating the market is not easy plus your return is reduced by their exorbitant fees. The average investor still has to deal with taxes, fees, and emotions which over time will reduce your return. Trust me. I’ve been there. That’s why I made the decision to switch to Index Funds and haven’t looked back.
What is an Index Fund?
An Index Fund is a type of Mutual Fund which usually owns a group of securities, like Stocks, Bonds, etc. So when you purchase one share of a mutual fund, you are owning a small part of all the securities the fund owns. This allows you to diversify very easily.
Index Funds follow a specific index, which is a hypothetical portfolio of securities representing a particular market or a segment. The most popular index is the S&P 500, which is an index of the 500 largest American stocks.
When you buy a share of an S&P 500 index fund, you are buying a fraction of a share of all the companies in the S&P 500. That’s right! With one purchase you can be invested in 500 companies and automatically have a diversified portfolio.
Index Funds vs Managed Funds
Now that we know what an Index Fund is let’s compare them to its counterpart: the Managed Fund. These are the original Mutual Funds. Typically you are paying a manager or managers to pick stocks for you. They do research, make phone calls, and visit companies they want to invest in. This amount of work can cost you some bucks. Most managed funds charge at least 1% for this service, with some moving closer to 3%. So, for every $100 you invest you pay $1-$3 dollars in fees, for every $1000 it would be $10-$30. This is not a small amount and will add up over years of investing. It would be worth it if the returns were great, but usually, they are not. Rarely do Managed Funds consistently do better than the stock market.
A common mistake is that if you’re paying more, you must be getting more; Managed funds must perform better than index funds. The truth is that over 90% of managed funds UNDER perform their target benchmark over the long haul. And their target benchmark is usually an Index Fund.
Low-Cost is the key
Since index funds are not managed, you pay a reduced fee. Why pay more for a list of companies that require no research? Remember, an Index Fund follows an Index, and as you probably guessed, there really isn’t a lot of work involved in determining this list. It’s pretty automated.
S&P 500 Index funds typically charge less than .5%. The most popular of the group are Vanguard Funds which charge a fee of .04%; that’s only 4 cents for every $100 you invest or $4 for every $1,000!
When researching which fund to invest in, get the prospectus or visit Google Finance, Yahoo Finance or the funds website and check the expense ratio. You should aim for .5% or less. Other things to look for are the minimum investment and account service fee. For example, to get Vanguard’s low expense ratio you need to purchase a minimum of $3,000 in a fund. An annual $20 fee is tacked on to your account if it’s less than $10,000 unless you sign up for e-delivery of statements and some other bells and whistles. So research the fund expenses before you send them any money. Remember, fees add up over time so keep them low.
Index Funds vs Index ETFs
Both funds and ETF’s consist of a mix of securities, and allow you to diversify easily but there are some key differences, so let’s review.
For example, an S&P 500 Index Fund and S&P 500 ETF are both made up of the same stocks. However, the Index Fund, like all Mutual Funds can only be purchased once a day, after the markets stop trading at 4 p.m. ET. You can enter an order to buy or sell shares of a Mutual Fund all day long, but it won’t actually happen until after the market closes, and what you will pay is the end-of-day price, not the price at the time you entered your order.
Conversely, ETF’s are traded like stocks. You can buy or sell them all day long as their price fluctuates, and that’s the price you get. The minimum purchase amount is one (1) share of the ETF, while Mutual Funds usually have an initial minimum dollar amount you need to meet.
Once you hit that minimum dollar amount on a Mutual Fund, recurring purchases may be as low as $1. This means you can buy less than one share of a Mutual Fund, called a fractional share. If a Mutual Fund is priced at $10 a share, and you purchase $1 in shares, you will own 1/10th of a share of that Fund. You could also purchase $15 of that fund and own 1.5 shares. ETFs must be purchased in whole share increments just like a stock.
Here’s a chart recapping the differences in an S&P 500 Index Fund and ETF:
| S&P 500 INDEX FUND | S&P 500 INDEX ETF | |
|---|---|---|
| Stocks | S&P 500 stocks | S&P 500 stocks |
| Price | Determined at market close | Fluctuates throughout the day like a stock |
| Minimum Purchase | Some have a minimum dollar amount you must meet | One share |
| Allows fractional shares | After you meet the minimum, you can buy less than one share at a time. | You need to buy in one share increments. |
Dollar Cost Average Your Way To Investing Success
Nobody can time the stock market. Warren Buffett never called a market high or a market low, so seriously, what chance do you have? You can minimize a potential loss if the market drops by dollar cost averaging your purchases over a period of time and slowly building your portfolio.
Dollar cost averaging (DCA) is a technique designed to reduce risk when purchasing stocks or mutual funds. If you have a 401k with your employer you’re already dollar cost averaging every time they purchase shares for you.
The idea behind dollar cost averaging is to repeatedly invest a set amount of money regardless if your investment goes up or down. If your investment decreases in value, you will be buying more shares at a cheaper price; if it goes up you’ll be making money on your existing investment. This is only recommended for long-term investors, so buying solid mutual funds, like Index Funds, is recommended.
Are You Convinced Yet?
If you still aren’t convinced Index Funds make sense maybe this will change your mind.
In 2008, Warren Buffet was so confident that the S&P 500 index would outperform an actively managed fund over the long term, that he wagered over $2 million dollars on it. A summary of the terms were:
“Over a ten-year period commencing on January 1, 2008, and ending on December 31, 2017, the S&P 500 will outperform a portfolio of funds of hedge funds, when performance is measured on a basis net of fees, costs, and expenses.”
The S&P 500 index won.
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