Getting Started Series Part 6- The Glory of Index Funds

GettingStartedSeriesPart6

This is a series intended to answer the question “I’m covering my bills, now what?” It’s for people who have a steady source of income and have a vague notion that they should be doing something more with their money, but don’t really know how to begin. This will go through what to do with that money post-bills, from setting up an emergency fund, to debt management, retirement, and investment. Although most of this information is applicable to civilians, we’ll also be providing resources and information specifically geared toward military servicemembers and their families.

So far through this series, we’ve worked through the importance of establishing an emergency fund, managing your debt, and taking advantage of tax-advantaged retirement accounts. Now we are moving on to investing. This information is applicable in choosing what your tax-advantaged retirement accounts can be invested in as well as your individual taxable investment accounts. In our last post we did an overview of investing, including a look into stocks and bonds. As I stated in that last post, today we will explain why we favor passive investing, particularly through index funds.

There are two ways of investing in stocks and bonds- active and passive investing. Active is when you individually choose stocks (or bonds). You might spend a lot of time researching different companies and watching the stock move up and down and deciding what and when to buy. You might get lucky and end up with a company that skyrockets, such as Apple. Or you may end up with a company that goes bankrupt. Despite all that research you do, stock picking is a lot like gambling. Sure, you might get lucky and the ball might land on your number on the roulette wheel. But the chances of that are pretty unlikely. Not only that, but active stock market investing requires frequent buying and selling of shares which accrues brokerage fees.  Passive investing, on the other hand, is more of a “set it and forget it” approach.

One form of passive investing is with the use of mutual funds. With mutual funds, a professional manages the money and selects the stocks (or bonds) that will be part of the fund. All of the individual investors’ money is pooled together to buy this variety of stocks and/or bonds. The manager is in charge of diversification. These mutual funds are usually set to a certain goal, such as low-risk or moderate-high risk. Mutual funds are a good option because you are automatically diversified within the fund and not all your eggs are in the same stock basket.  The trouble with mutual funds is they tend to have a high expense ratio (which we will discuss in Part 8). Essentially, this is the percentage that the brokerage company takes off the top to manage the fund. After all, that investment manager has to make his living too.

But even better is a certain class of mutual funds called index funds. There are a few different types, but I’m going to delve deeper into the S&P 500.

The S&P 500 is an index of the stock market. It’s used to measure the growth or decline of the stock market. The index committee chooses which companies are included (and technically there are currently 502 included, see the list here. One of the criteria is “a market capitalization greater than or equal to $5.3 billion”, so these are some major companies we are talking about here.  In fact, if you go through the list, you’ll probably recognize many of the big names. Additionally, the index is weighted according to its market value. This means that Company X that has 6 billion shares available to the public being sold for $200 per share will have more weight in the index than Company Y that has 3 billion shares available to the public at a price of $100 per share.

 

File:Daily Log Chart of S&P 500 from 1950 to 2013.pngSource

Here is a graph of the S&P 500 from 1950 to 2012.  You can see that this indicator of the stock market grows in the long term. Inflation only accounts for 3% of this growth. Adjusted for inflation, the S&P 500 averages about 7% a year. (See source.)

Seeing that the S&P 500 always rises in the long term, John Bogle, who founded Vanguard, had the idea to create a mutual fund that invested in those exact same 500 companies at the same weight as the S&P 500. And thus index funds were invented in 1975. (You can read more about the origin here)

What’s so great about index funds?

  1. They have low expense ratios. Remember how I said that those mutual fund managers have to earn a living too? Well with index funds there isn’t a mutual fund manager. Since the companies in the S&P 500 were already picked and weighted by a committee, a computer does the work of following the index. Not paying a manager means it costs the brokerage company less money, which they usually pass on to you as the consumer. We will discuss expense ratios in depth in part 8 and see why they matter so much.
  2. They are self-regulating. The companies used in indices, whether it be S&P 500, Dow Jones Industrial Average, or something else, change somewhat regularly as companies go bankrupt or merge and other up starters come in to fill their shoes. Think about this- did our economy tank when we lost travel agents and book stores and VHS rental stores? No, because other businesses like internet providers and cell phone providers and app makers came into business and began to employ people and make sales and our economy chugged along just fine. If a company starts to perform poorly, the committee will make it worth less weight or take them out of the index and you won’t invest in them anymore. If a company starts to really take off and dominate the market, the committee may add them and you will invest in it. This also means that you don’t have to worry about selling shares of a certain company that you think is going to tank or rush to research an internet up-starter that you heard about from your hipster nephew. You are invested in the companies that are driving the market, and since the market always rises, so will your money. If a certain company isn’t driving the market anymore, then they are deleted from the list. If a company does become a big player in the market, then they are added to the list. All without your interference, labor, or research.
  3. They are already internationally diversified. I will be frank here, I am personally opposed to investing in international accounts. One reason for this is because the currency exchange adds complexity, and a perceived increase or decrease in the international market could actually be a change in the value of the dollar. They are also more difficult for doing taxes- I know because one of my mutual funds that I owned had some money invested internationally and reporting it annually was never fun. It’s probably starting to become clear here throughout this series that we favor simplicity, and the international funds just add an extra layer of complication unnecessarily. But at the same time, I recognize that it’s a smart move in today’s global economy to not just invest in domestic goods. However, since it really is a global economy, those top 500 businesses in the S&P 500 are doing business around the globe. In that way, you are already tied to the international market. Let’s do an example here- let’s imagine Country A becomes insanely rich. What are those citizens in Country A going to do with their newfound wealth? They’re going to buy stuff. Like smart phones. And computers. And things from the internet. And they’ll eat out more often. And what do you know? Companies like Apple, IBM, Best Buy, Amazon, Ebay, Chipotle, Coca Cola, McDonalds, Starbucks, and Hewlett-Packard are all part of the S&P 500. So if another country begins to see a large growth in their economy, these top companies will do lots of international business, and your money will continue to grow. Adversely, if companies do not do well in the international market, well that’s where the self-regulating aspect kicks in and they fall off the index.

Need more convincing?

Here’s a collection of articles from around the web further explaining the beauty of index funds:

1 ) http://jlcollinsnh.com/stock-series/

This stock series is amazing. It’s long, but well worth the read. Mr. Collins does an excellent job of breaking down how index funds work and explaining their success. There’s also some great discussion in the comments. I highly recommend this series.

2 ) http://www.investopedia.com/articles/professionals/062915/indexing-vs-stock-picking-which-better-right-now.asp

This article from Investopedia analyzes active investing vs passive investing. In the table posted they show that passive investing comes ahead. Although the margin is small, passive investing is also easier, less time consuming, and cheaper to do.

3 ) http://www.marketwatch.com/story/warren-buffett-to-heirs-put-my-estate-in-index-funds-2014-03-13

Warren Buffett, millionaire investor, advises his heirs to invest in index funds.

4 ) http://www.mrmoneymustache.com/2011/05/18/how-to-make-money-in-the-stock-market/

If you follow personal finance blogs, then you have likely read Mr. Money Mustache. In this post he explains why index funds are the best way to make money in the stock market.

5 ) http://www.budgetsaresexy.com/2014/06/lazy-one-fund-investing-strategy/

This post really stands out to me because it’s similar to my situation. Basically, J. Money realized that having 47 different funds was “ridiculous” (his words, not mine) and he synthesized it down to just one index fund through Vanguard- VTSAX. Davin and I just went through a recent cleansing of our investments as well. Turns out my 403b from a previous employer was in 12 different investments! My bad for not checking up on it sooner. We ended up consolidating as much as possible into index funds at Vanguard and mainly VTSAX. Anyways, J. Money explains here why the “lazy” strategy of just one index fund is the way to go and it’s essentially the same strategy that we are aiming for as well.

Where to get them:

Every brokerage company has index funds, including USAA, Fidelity, Charles Schwabb, American Funds, and many more. And of course they are available at Vanguard, the company that started index funds. Your employer provided retirement account likely has one as well. The buzz words you’ll often see that clue you in that it is an index fund are “market”, “500”,  and “large cap”, to name a few. If you’re not sure, just ask.

Additionally, the TSP provides index funds as well. The C fund is an S&P 500 index fund while the F fund is an index fund of the bond market (this is the same principle as above, just with bonds rather than stocks).

We’ll discuss more about shopping for mutual funds and index funds in the next post in this series.

In conclusion…

John Bogle is quoted as saying, “Don’t look for the needle in the haystack. Just buy the haystack!” And that’s really the essence of the index fund. Instead of picking individual stocks that may or may not be successful, just invest in the market because history has shown us that the market always grows in the long term.

It took me a long time to wrap my head around index funds. But now we have almost all of our investments in index funds. They’re diversified, they grow with the market, and they are inexpensive in terms of expense ratios.

Now that we’ve explained passive investing and why it can be so successful, we’re ready to shop for our funds. In our next post in the series we will explain what to look for when choosing a mutual or an index fund as well as where to get them. Thanks for joining us today!

Disclosure: The information provided here is for educational purposes. We are not professional financial advisors. We are also not affiliated with any of the companies mentioned above. Do your own research before making any decisions.

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2 Comments

  1. Davin Davin
    December 30, 2015    

    Where did Part 5 go? This is really awesome stuff!

    • December 30, 2015    

      It got categorized incorrectly. Should be fixed now! 🙂

Questions? Comments? Witty remarks?