Have you ever wondered what all the hype is around index investing? Why is it that so many people love it so much? Let’s dive in!
What is index investing?
An index fund is a pool of money that is invested in such a way that follows or tracks an index. What is an index? An index tracks a group of securities or assets, some great examples in the United States are the Standard and Poor’s (S&P) 500, the Dow Jones Industrial Average, and the NASDAQ.
The S&P, for example, is a list of the 500 largest companies in the US. It is rebalanced every so often to remove companies that fall out of the top 500 and bring in the companies that grow into the list.
An index fund that tracks the S&P 500 would simply use the pool of money it has to invest in exactly (or in many cases with at least a majority of the funds) the same weighting that the S&P 500 is made up of! The top 3 companies in this index (as of this writing in September 2021) make up the below portions of this index:
Apple – 6.1%
Microsoft – 5.9%
Amazon – 3.9%
The best part about index funds? They often have extremely low expenses because the fund management team doesn’t have to do anything other than rebalance the investments to continue to match the index!
Index fund? Mutual fund? Exchange traded fund (ETF)?
These words are often used interchangeably, mistakenly so. While they can all accomplish the same thing, they are all different.
Mutual funds & ETF’s are types of funds that one can invest in. They are fundamentally similar but work somewhat differently. There are multiple different types of mutual funds, but for simplicity’s sake we won’t dive too far into those specifics (spoiler, I do not like mutual funds and am very pro-ETF).
Mutual fund prices and transactions, in most cases, are only updated and processed once a day at the close of the stock market. Fundamentally, they are a collection of funds that a fund management team invests in such a way as to meet the goals and purpose of the fund.
For example, a mutual fund may be considered a, “growth fund” where it tries to beat market returns by only investing in growth stocks. In many cases with mutual funds, the management team actively manages the fund and this will result in higher expenses. When a fund is actively managed, the fund’s management team is trading in and out of positions in hopes to obtain as high a return as possible.
The counterpart here would be a passively managed fund – like most index funds – where the team’s only objective is to invest the fund’s money so that the portfolio matches the index it is tracking. There are some funds that boast consistently beating the market, but more often than not these actively managed funds fail to do so.
Why are fees so important to keep in mind? They can absolutely destroy your returns! This video below demonstrates that!
One last important note on mutual funds, in most cases there will be a minimum threshold that you need to invest (often $2,500, $5,000 or in some cases $10,000) but you do not necessarily buy individual shares. So long as your investment is over the minimum threshold you can invest any amount.
Exchange traded funds (ETF’s) are what I like to consider the grandson of mutual funds. They trade in the same way that stocks do, with prices constantly updating when the market is open, and you buy shares of them just like you would a stock.
Many of the fundamentals are similar, there is a team that manages the fund in such a way as to match the goal. Similarly to mutual funds, there are also ETF’s for everything you could possibly think of! There are ETFs that are collections of airline stocks, oil stocks, growth stocks, you can even buy ETF’s that are double or triple leveraged to give 2x or 3x returns if an index goes either up or down.
You really can find an ETF that invests in just about anything!
How do I invest in index funds?
Whether you decide to invest in a mutual fund that tracks an index or an ETF that does, most major brokerages allow you to buy most mutual funds and ETF’s. There are exceptions, but simply setting up a brokerage account and funding it will allow you to make the investment!
All you would need to do is decide how much you want to invest, and which index (or indices) you would like to invest in!
As mentioned above, mutual funds often have minimum investment thresholds and some even limit when you are allowed to sell. ETF’s are often a lot easier to invest in in my opinion.
What is the benefit?
Investing in an index fund is arguably the easiest way to achieve diversification. There are arguments that diversification limits the growth you can potentially achieve, but if you are a beginner they are an excellent place to start. On average, the S&P 500 index rose by 12.31% (15.06% with dividends reinvested) each year in the 50 year period between 1970 – 2020 (source here).
The worst of those years was in 2008 where the S&P 500 tanked by -38.49%, but the best was in 1995 when the index rose by 34.11%. When it is all said and done, averaging a double digit return can bring about some incredible growth.
The best part? You barely have to lift a finger! Actively making trades can take hours of research, careful planning, and diligence. More often than not, you probably will not outperform the market as a whole despite all of that work. All it takes is a handful of clicks and you can own an ETF that tracks the S&P 500 and you will likely see consistent returns in the long run. All at a fraction of the time and effort.
The even better part? If you wanted to match the diversification granted by an index fund that, per our example, tracks the S&P 500 you would have to have tens (possibly hundreds) of thousands of dollar to buy enough shares of each of the 500 largest companies to properly allocate the weighting to match the index. This would take a considerable amount of work and you would spend so much of your time rebalancing to continually match the index.
There are ETF’s that track all of the major indices that run anywhere from $10 a share to $500 a share. Considerably more affordable than building a portfolio from scratch.
That is where the expense ratio factors in. The most popular S&P 500 ETF’s have extremely low expense ratios, but that is what pays the fund management team to do all of that hard rebalancing work for you. Absolutely worth it in my opinion.
Concentration or diversification?
The one argument I have seen against index funds is that they can bring about too much diversification. If you are new to investing, this should not be a concern to you. One of the biggest reasons that this is brought up is that many of the greats – Warren Buffet, Charlie Munger and the like – invest in only a handful of stocks and have seen considerable returns as a result.
The problem? They have decades of experience and know how to pick the right companies to invest in. Most people do not have this skillset. Many regular people with little to no experience attempt to outperform the market by investing in things that are extremely volatile in hopes to find, “the next big thing”.
This rarely pans out, you are almost always better off just buying the whole market and enjoying some consistent returns.
Looking for an in-depth breakdown of Index Investing? This ebook is an excellent resource!
As always, thank you so much for taking the time to read this! I put a lot of work into this one, I hope it was helpful!
Please do not hesitate to reach out to me with any questions, comments, or suggestions!