Index fund investing has become quite popular, with the likes of Warren Buffett supporting it as a way to invest in the stock market.
Related: Learn to invest like Warren Buffett
In fact, Buffett recommended The Little Book Of Common Sense Investing (by John Bogle) over advice from most financial advisers.
John Bogle is the father of index fund investing.
He’s also the founder of Vanguard, which is one of the most respected and successful companies in the investment world.
Index fund investing has become so popular that over 20% of all investment in the US equity markets is believed to be through an index fund.
Investing doesn’t have to be difficult
Most people consider investing to be hard and usually have no idea where to start.
I’m not in that camp. I try to keep investing simple, and index fund investing is my primary way of doing this.
This simple approach is also what Jim Collins writes about in his highly recommended book called The Simple Path To Wealth.
When you invest in the stock market, you can either buy an individual stock or you can buy into a basket of stocks i.e. funds.
In my humble opinion, the only people who should really be buying individual companies are:
- Those who understand how to value companies,
- People who have sufficient time to evaluate companies and their financial statements
- Individuals who are buying stocks that are part of the Dividend Aristocrats
Warren Buffet fits into all of the above, and as such can afford the time and resources necessary to buy specific companies as he does through Berkshire Hathaway.
For the rest of us, index funds are the more reasonable option.
Given the significance and ease of investing in index funds, it is important to understand what they are, why you should consider investing and what the risks are.
What is an Index?
An index is a small slice (sample) of the market or a way of segmenting the stock market into smaller chunks.
This sample is chosen by people (e.g. institutional investors) who come up with the parameters of what individual holdings should be included.
Examples of an index include the S&P 500, or 1000 Index, which are a collection of the largest 1000 and 500 companies in the UK and US Stock markets, respectively.
Index funds help investors track the performance of the stock market.
Because human beings select the stocks included in the index, all indexes are not created equally. There are good, mediocre, and bad indexes.
Personally, I like the Schwab S&P 500 Index Fund (SWPPX). Not only does it track the performance of the 500 largest companies in the United States, it has an expense ratio of only 0.02 percent.
What is an Index Fund?
An index fund is a basket of individual holdings (e.g. stocks or bonds) i.e. mutual fund that aims to track a particular index.
That fund itself is a pooled structure (i.e. pot of money).
Therefore, if you buy the Schwab S&P 500 index fund, you’re buying a portfolio of stocks.
Aa portfolio manager is responsible for tracking the index i.e. replicating the results of the S&P 500 index.
This is somewhat counterintuitive – most professional investors believe they can beat the market, hence this is the reason why they select individual stocks themselves.
Index investing is a passive form of investing
Active investing means there is a manager who actively (gets paid handsomely selects stocks believing he/she can outperform the stock market.
What are the Advantages of Index Fund Investing?
1. Cost
One of the biggest advantages of an index fund is its lower cost. Investing in an index fund requires little or no upfront costs. Ongoing annual costs are typically anything from 0.04% to 0.25%. As you can see, the Schwab S&P 500 index fund is a real bargain.
However, an active fund manager will typically charge you 5% upfront commission, followed by an annual management charge of around 2% – as these fees are charged regardless of the fund’s performance!
Watch out for these costs as they can play a large role in the overall returns on your money over time. These high fees are exactly what has made Wall Street rich!
One way to know whether you are investing in an index fund is to look at the Total Expense Ratio (TER). The TER should be relatively small if it’s an index fund.
2. Diversification
Investing in an index fund means that you own a piece of every company in the index.
As such, you benefit from diversification as opposed to picking only one or a handful of stocks.
3. Self-Cleansing
Over time, the makeup of the major indexes such as the S&P 500 changes.
Poor performing companies drop out and are new ones are added each year based on performance.
This self-cleansing work is done for you essentially if you buy the index, rather than having to do this yourself through stock picking.
4. Emotional Stability
Index investing gives you peace of mind by removing the emotional and psychological aspects of investing.
If you had a portfolio of 10 stocks and 2 or 3 of them were performing very badly, due to an industry shock such as the 2008 financial crisis, you’d likely be considering selling.
However, investing in index funds removes your short-term fear as you’ll not see these bleeps play out explicitly in the price of the index fund.
You’re therefore more likely to forget your investment (as you’re meant to) and let it work for you over the long term.
5. Anyone Can Do This
You don’t need to understand a company’s balance sheet, income statement, or be good at math or understand how compounding works to get involved here.
All you need to do is establish an online brokerage account with a company like Charles Schwab or Vanguard.
6. Good Investment Returns
Index fund investing gives every investor the opportunity to achieve stable stock returns without all the volatility.
Over time, a broad-based index fund typically returns on average about 7 percent.
In addition, the low cost of index funds means that your net returns can build up and compound over time.
Is there a downside to index fund investing?
Investing is not risk-free, there is always a chance that you can lose money. Although index funds are generally less volatile, there is a degree of risk involved that you should be aware of.
1. Market Risk
Although index fund investing removes “specific risk” associated with picking individual stocks, you’re inevitably exposed to market risk.
Market risk is simply the possibility that the investor may lose money if the market goes down. If you want to be invested in the stock market, you will be exposed to market risk. There is no escaping it.
2. Sector and Industry Bias
Most index funds can be heavily concentrated in specific sectors and industries.
For example, the S&P 500 could be argued to be heavily weighted towards Financial and Tech companies.
How To Invest In An Index Fund?
Index funds come in two formats:
- Tracker Fund or via
- an Exchange Traded Fund (ETF)
Both have the same objective, which is to track a given index.
Both traditional tracker funds and ETFs maximize your returns due to their ultra-low costs; there is no need for expensive fund managers and their exorbitant fees.
You can purchase index funds through typical fund providers such as Charles Schwab and Vanguard, etc.
How Do You Succeed Investing In Index Funds?
The key to succeeding here is as follows:
1. Start and Invest Consistently
Start investing as soon as you can and keep your investing consistent e.g. via a monthly direct debit.
This not only encourages you to keep investing, but you also benefit from time diversification i.e. dollar cost averaging.
2. Focus on broad-based high-quality index funds
Choose an index fund that is sufficiently broad-based.
The S&P 500, for example, gives one exposure to 500 of the largest U.S. companies by market capitalization.
These large companies generally have a global presence and earn income on several continents. This diversity means their income is not concentrated in one market.
3. Have a long-term view in mind
Behavioral biases lead to people making poor decision i.e. buying high and selling low.
It’s better to buy and just forget about it.
Warren Buffett summarizes this quite well:
I recall reading about a study Fidelity conducted on how Fidelity account holders had performed over time.
The best performers were dead people, followed by the accounts of people who forgot they had an account at Fidelity.
Having a long-term view (25 to 50 years for example) could be game-changing not just for your life but generationally as you allow time for compounding to work.
4. Reinvest any dividends you receive
Doing this automatically will add fuel to the compounding machine that is your portfolio.
Related: The Power of Compound Interest
5. Don’t sell when a crash happens
Stock market crashes are guaranteed events. The last crash was in 2018, ten years ago. Therefore, another crash will probably happen in the near future.
Instead, of trying to time the market and selling during a crash (very bad idea), wait for a while, then buy when the market is being sold at a discount.
To Conclude:
To paraphrase John Bogle from his book The Little Book Of Common Sense Investing:
The way to wealth for those in the investing business is to persuade their clients, “Don’t just stand there. Do Something”. I.e. Start buying stocks.
But the way to wealth for their clients in the aggregate should be the opposite, “Don’t do something. Just stand there”. I.e. Ride the index and let time work!
Index fund investing and the passive movement is here to stay and there will continue to be a relentless push against it from the industry.
You, however, now know what to do and how to remove complexity and demystify stock market investing.
The question is, how soon will you begin investing in index funds to put you on the path towards Financial Independence?
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