Index Funds: A Beginner’s Guide

Have you ever heard of an index fund before?

If you haven’t don’t worry, this post will cover everything you need to know.

Index funds are hands down the easiest and most efficient way to invest. 

But don’t take my word for it. Speaking about index funds, Warren Buffet said,

“A low-cost index fund is the most sensible equity investment for the great majority of investors”

So it’s fair to say investing in index funds is one of the smartest moves you can make with your money.

Index funds are the solution for anyone who –

        • knows very little about investing
        • wants to set it and forget it
        • doesn’t want to pay excessive fee’s to an advisor
        • wants consistent positive returns over the long term

In fact, investing in low cost index funds can you save you over 100k in your retirement plan. They are simply the best investment to make for 99% of investors.

Ready to learn more? Let’s jump in

What are index funds?

An index fund is a type of mutual fund that closely matches a financial market index.

For a more sophisticated definition, Investopedia says,

“An index fund is a type of mutual fund or exchange-traded fund (ETF) with a portfolio constructed to match or track the components of a financial market index, such as the Standard & Poor’s 500 Index (S&P 500).”

Okay, that’s still super confusing. Let’s break this down. To better understand what an index fund is, let’s look at the difference between stocks, mutual funds, and index funds.

When you invest in the stock market you are investing in stocks. Stocks are a share of an individual company.

stocks

If you want to invest in a bunch of stocks in one fund, you can invest in a mutual fund. A mutual fund is just a grouping of stocks.

mutual funds

Now, if you want to invest in a whole lot more stocks all in one fund, you can invest in an index fund. An index fund is a type of mutual fund, but there are a lot more stocks because you are tracking a specific market index. For example – if you own an S&P 500 index fund, you own a piece of 500 of the top publicly traded companies.

index funds

What are the benefits of index funds?

There are three major benefits of investing in index funds.

Broad Diversification

When you invest in index funds your investment is spread out amongst hundreds and sometimes thousands of different stocks. Since you are invested in so many different stocks, the performance of one individual stock will not have a huge impact on your returns. Index fund investing is a less volatile approach to investing, meaning you are taking on less risk.

For example – someone who invests solely in Tesla stock is taking on a lot of risk. They will benefit greatly if the stock goes up but will lose a lot if the stock goes down.

Low Cost

All mutual funds have fees outlined in an expense ratio.

An expense ratio is an annual fee charged to investors to cover the operating and administrative expenses of mutual funds.

Actively managed mutual funds have higher expense ratios because someone is responsible for manually buying and selling the stocks within the fund.

Passively managed mutual funds, such as an index fund, have lower expense ratios. Since their design is to track the performance of a particular index, the stocks within the portfolio rarely, if ever, change. Therefore, there is no need for a fund manager to manually buy and sell. This brings the cost to own the fund WAY down.

Consistent Returns

There’s a reason Warren Buffet said, “”My regular recommendation has been a low-cost S&P 500 index fund,” in his 2016 Berkshire Hathaway annual shareholder letter.

Index funds perform very well over the longterm.

For example, the S&P 500 delivers average annual returns of almost 10% through the last 100 years. In fact, more than 80% of actively managed mutual funds underperform the returns of index funds over the longterm.

So not only are you investing at a very low cost, but you are getting returns that are greater than that if you someone was managing the account for you.

Where do I invest in index funds?

You can purchase index funds from a brokerage inside an investment account. Investment accounts have different pro’s and con’s depending on your goals. A general rule of thumb is to invest inside retirement accounts first because of their tax-advantages.

My advice is to invest in the following order:

1. 401k/403b (Up to match if applicable)

The 401k, 403b and 457b are employer sponsored retirement accounts.  If your job offers an employee match within these accounts, you are basically getting FREE money for contributing towards your retirement. Your employer will match a certain amount or percentage of your contribution so you would be silly not to take advantage of it.

2. HSA (max $3,500/year)

A Health Savings Account (HSA) is a medical savings account offered by your employer. If you are enrolled in a high deductible health insurance plan (HDHP), you can qualify for a HSA. Similar to retirement investment accounts, there are tax-advantages for contributing.

3. Roth IRA (max $6,000/year)

The Roth IRA is a self directed retirement investment account. Since this account is not employer sponsored, you can set-up an account with any index fund provider that you wish. My suggestion is to set up a Roth IRA with Vanguard. If you’re interested, check out this quick and simple Instagram post from @personalfinanceclub that walks you through the process.

4. 401k/403b/457b (max $19,000)

As mentioned above, the 401k, 403b, and 457b are employer sponsored retirement accounts. It’s worth noting that whether you have access to index funds in these accounts will depend on the plan offered by your employer. It may not be worth investing in these accounts (above the employee match) if you only have high fee investment options.

Check out my post “403b Plan: What Every Teacher Should Know Before Signing Up” for more on the impact of fees.

5. Standard Taxable Brokerage

A Standard Taxable Brokerage Account is a basic investing account opened by yourself through a brokerage firm. It allows you to deposit funds for buying and selling investments with very little restrictions. Unlike retirement investment accounts, there are no tax advantages to a standard brokerage account. The nice thing about these accounts is the flexibility. There are no maximum contributions and the brokerage that you decide to use is up to you.

Best index funds to buy?

The three biggest index fund providers include Vanguard, Fidelity, and Schwab. Each of these companies offer an array of different index funds at very low costs (usually less than .10%).

You can purchase index funds directly from these companies or through other brokerages. Just be aware that if you go through other brokerages, there may be additional transaction fees.

Here’s a list of my top 5 favorite index funds.

1. Vanguard 500 Index Admiral Shares (VFIAX)

Minimum investment: $3,000
Expense ratio: 0.04%.

2. Vanguard Total Stock Market Index Admiral Shares(VTSAX) 

Minimum investment: $3,000
Expense ratio: .04%

3. Schwab S&P 500 Index Fund (SWPPX)

Minimum investment: No minimum
Expense ratio: 0.02%

4. Fidelity 500 Index Fund (FXAIX)

Minimum investment: No minimum
Expense ratio: 0.015%

5. Fidelity Zero Large Cap Index  (FNILX)

Minimum investment: No minimum
Expense ratio: 0.0%

The Bottom Line

Investing in index funds is one the smartest financial decisions you can make. There is very little risk over the long term and the returns are better than the vast majority of actively managed mutual funds. Remember, you don’t need to be a math genius to invest! Anyone can do it, and you can set everything up during one afternoon. Good luck on your financial journey, and please consider subscribing! 🙂

 

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FreshLifeAdvice
1 month ago

Great intro to Index Funds, Keelan – love your blog! I completely agree on your order of investing. Even as an experienced investor, I’m a huge advocate of index funds as we’ve learned “Slow and steady wins the race.” Another index to add to your list would be the ETF VTI, which has an expense ratio of 0.03%. Keep up the great work!