I get it; you’re pretty new to this whole personal finance thing. Maybe you’ve just created your first budget (hopefully by following this post). Maybe you’ve just paid off your last penny of debt. Maybe you’re developing a plan to conquer the world, and eventually the solar system, and your first step is getting rich.
If that last one is your goal, then you’re in luck, because I’m here to educate you on my favorite way to invest in the stock market. The entire stock market. Nearly effortlessly. Yeah, you can call it a “get rich” scheme.
I’m talking about index funds. Basically, an index fund is a fund whose goal is to mirror the performance of a particular stock market index, such as the S&P 500, as close as it possibly can. Index funds do this by investing in particular stocks that make up that index.
For example, the Vanguard 500 Index Fund Investor Shares (Ticker: VFINX) is an index fund that invests in 500 of the largest companies in the United States. This fund is designed to match the performance of the S&P 500, making it the “benchmark” that VFINX is compared to.
Benefits of Index funds
Ease of Diversification
The main benefit of an index fund lies in giving the average investor a way to gain diversified holdings in various areas of the stock market. Rather than buying individual stock in Bank of America, General Mills, and Microsoft, one could simply invest in VFINX and gain holdings in all 3 of those companies, plus 497 others.
This is especially useful for those who don’t have the time, desire, or inclination to research individual stocks in an attempt to make a smart investment decision (Hint: investing in individual stocks is NOT a smart investment decision. Unless you’re Warren Buffet. Or from the future).
Index funds also have generally small expense ratios. An expense ratio is the percentage of assets that is required to run the fund. Think operating costs. VFINX’s expense ratio is 0.17%. Index funds have lower expense ratios mainly because there’s really nothing to them: they’re not actively managed like other types of mutual funds, the parts that make up an index fund rarely change, and there’s hardly any overhead. This means that you get to keep more of your profits, as opposed to actively-managed mutual funds that have fund managers, analysts, and other people and services to pay for, which are costs that get passed on to the customer.
Armed with this article by the Motley Fool, some basic common sense, and a 3rd grade education , one can easily see why index funds are such an awesome investment, especially when compared to actively-traded mutual funds. The general rule of thumb is that actively-managed mutual funds, for all their expert stock pickers and newly-discovered revolutionary strategies, return less than that of the stock market average much more often than not.
The reason for this is two-fold: we already touched on the first reason, that actively-managed mutual funds have much higher expense ratios due to all the extra expenses they incur. The second reason is that it’s incredibly difficult to pick individual stocks like these mutual funds do and consistently beat the overall stock market average. Yes, your uncle’s girlfriend’s brother-in-law (southern relationship perhaps?) has shown you his returns for the last year in the actively-managed mutual fund he owns. They look really good too, at 22.3%. But that’s one year. The trick is to consistently, year after year, have awesome performance like that.
It just doesn’t happen.
But 22.3% is still a 22.3% return on my investment you say. Yes, you’re right, but let’s play with some numbers. If you have $1,000 invested in this mutual fund, and you get that 22.3% this year, then you’ve just made $223, minus all the fees involved. You’ve still only got $1223 dollars though… you’re not exactly set for life.
So you’ll just invest more you say. Okay, let’s say after this year, you’re so thrilled with your broker that you throw an extra $10,000 into your mutual fund. Your balance is now at $11,223. Unfortunately, this year, your broker doesn’t do so hot. He picks a few stocks that tank, despite the various “5-Star Ratings” and such, and he was so sure about his decision that he put the majority of your money in those stocks. You lose 39.6%. Now you’re balance is down to $6778.69.
That’s not to say that this can’t happen in an index fund over the period of just two short years, but an index fund that closely follows the overall stock market will get an almost guaranteed return of 8%-10% in the long run. Who knows where that mutual fund will end up over the years, and in fact it’s generally accepted that the only thing mutual funds do consistently is under-perform the overall stock market.
So why would you choose a product that gives you less and costs you more?
Disadvantages of Index Funds
Despite everything I just said about actively-managed mutual funds not making as good of a return as index funds over a longer period of time, index funds still only get an average rate of return (compared to the overall stock market’s average). By investing your money in these index funds, you’re limiting the amount of cash you could invest in other things, such as your company’s 401(k) (especially if they match… that’s free money) peer lending, or starting your own business. While these things could present a lot more risk, they also have the potential for a greater return.
Every once in a while, a company will leave an index, to be replaced by another. Let’s say Microsoft goes bankrupt (then of course the world would end), and as a result is no longer included in the S&P 500. Chances are it’ll be common knowledge that Microsoft is leaving the S&P 500, resulting in a depressed stock price. Conversely, when one company leaves, another must join. It’s not the S&P 499, after all. There will be speculation and a generally favored candidate, which causes that companies stock price to rise.
Basically this means you’re selling low and buying high, which is really not the best way to go about investing in anything. Period.
But Wait, There’s More
Now you know a bit about index funds, you personal finance newbie you. There’s always more to learn though, and there are a ton of different index funds out there, covering different sectors of the domestic market, as well as international markets and more. You don’t have to be an expert to get started though, in fact, taking what you’ve read here should be more than plenty to get you started. Simply jump on the internet (I guess you’re already on it, aren’t you…), Google “online brokers”, do your research, choose one, and start investing in something… the sooner you start, the better off you’ll be. Be sure to check back for more articles about index funds, other investment vehicles, and generally awesome, entertaining, and thoroughly engrossing content covering the many facets of personal finance.