How Index Funds Make Investing Easier and Less Intimidating

Once I finally paid off my debt and generally got my financial life back on track, I was ready to start investing. Everything I read told me to check the index funds, which I did. Of course, this is a great tool with a number of benefits for new and experienced investors.

What is an Index Fund?

You’ve probably heard the word ” fund” before in the context of investing. There is a complex official definition , but in basic terms you need to know , a fund is simply a group of small investments that you buy in one package. Depending on the type of fund, these small investments can be large companies such as Google, Apple, or Microsoft. These can be government bonds. In any case, a fund is one large investment made up of smaller assets. It’s like buying an entire collection of compilations of your favorite artists instead of buying each track separately.

An index fund is a fund that reflects a specific index , and an index is just a measure of the financial market. For example, you’ve probably heard of the S&P 500 . It is an index that measures the 500 most economically powerful companies in the United States. It would be a nightmare to buy and sell the right amount of shares in each of these companies alone. Or worse, research your companies from scratch. Who has time for this? Index funds do all this work for you; you just buy one investment. If the index is doing well, the index fund is doing well. If the index falls, then the index fund falls. And that’s why everyone loves them: the research is done for you, and so is the choice.

There are many different indexes, and here are some of the most common ones . Firms such as Vanguard , Fidelity, and Charles Schwab have developed different index funds for all of these and many other indices. Here are a few:

If the S&P rallies, the VFINX Vanguard can be expected to rise. If the S&P falls, so does VFINX. The same goes for each index and its corresponding fund. Historically, the S&P averages 10% (pre-inflation) annually . Therefore, it should come as no surprise that VFINX has a similar recoil .

Index funds are great for long-term investing

Index funds have several advantages that make them great for long-term investment:

• Diversification
• Simplified, reliable performance
• Low fees

Each of these benefits is key to a strong set and forget portfolio .

Diversification

When it comes to investing, diversification is very important. You’ve probably heard the saying, “Don’t put all your eggs in one basket.” In monetary terms, this means: Don’t put all your money in one company, asset, or asset class.

For example, Google is a secure and stable investment. However, you still don’t want to put your every dollar on Google. Despite how safe the company is today, betting on Google and Google alone to fund your retirement is dangerous. You are at the mercy of everything that can go wrong with one company. If they decide to spend every penny on the Google+ revival, you will be a little worried. In short: if something goes wrong, you lose everything and you completely screwed up.

On the other hand, if you invest in a bunch of other assets, you’re still okay if Google gives up somehow. In a nutshell, this is diversification, and this is how index funds work. You invest in hundreds or thousands of different assets, be it company stocks or government bonds . In short: index funds have diversification built in. The banks and organizations that set the index specifically select companies for diversification.

Simplified, reliable performance

With an index fund, you make a simplistic bet on a reliable index such as the S&P 500. Of course, this index has its ups and downs, but over time, its post-inflation rate of return averages 6-7% . This is not bad for long-term investment, namely retirement savings.

Here’s how JD Roth talks about it in Get Rich Slowly :

Do index funds always come out ahead in a given year? Not at all. In fact, they are usually found in the middle of the pack. By definition, index funds produce average market returns – nothing more, nothing less.

However, in the long run – ten, twenty or thirty – a remarkable thing happens. Index funds are growing rapidly. It turns out that the average performance in the short term is actually above the average in the long term.

In short, index funds need to be stable and tiring. They won’t skyrocket and make you rich overnight, but nothing will, and over time, it’s a pretty safe bet.

Low fees

In the case of other funds, the advisor or investor chooses your individual investment. He or she watches them closely and then buys and sells these individual investments according to their results. They want to beat the 6-7% average return by actively managing your fund. We call this active investing , and you pay for the work that goes into it.

When you buy a fund, you pay on a pro rata basis, no matter what, and this is a commission that includes all the costs the fund incurs. With active investment, this ratio includes higher management fees for additional time and effort.

On the other hand, since index funds are simply meant to mirror the index, they don’t require much maintenance at all. Again, if the index is performing well, then your index fund is performing well. If the index falls, your index fund will fall. We call this set and forget investing or passive investing . No maintenance is required, so the fees are much lower.

This Morningstar study found that index funds outperform actively managed funds over time. Active investors question this research, but one thing is for sure: index funds tend to be cheaper than actively managed funds, and over time, this can significantly affect your profitability. Depending on the fund, active funds may well outperform the market, but you will pay the price. It’s worth it sometimes, but you know what you get with index funds: low fees.

Now the downside: most ETFs have a fairly high buy-in limit. It can be anywhere from $ 3,000 to $ 10,000. I know this is a lot. However, keep in mind that you are investing in thousands of different assets at the same time, which costs money. If you want to start investing with index funds but do not have enough savings, you will have to accumulate enough funds in your investment account until you reach that number. Once you’ve done that, it’s time to think about choosing and buying your fund.

How to choose an index fund

Before choosing index funds, you need to know your asset allocation in order to know which index to invest in. And you need an investment account, such as an Individual Retirement Account (IRA) with a brokerage firm, to actually buy the fund.

A solid investment portfolio is well balanced across two main asset categories: stocks and bonds. We’ve told you how to figure out your asset allocation in detail , but it depends on your risk tolerance and how long you will need the money (this usually means retirement). As a general rule of thumb:

110 – your age = the percentage of your portfolio that should consist of stocks

However, this only covers the very basics. To buy index funds, you need to know which asset classes to buy in, for example, international stocks or US bonds. Tools such as checking the portfolio the Personal by Capita l or Calculator Bankrate distribution of assets can help you figure it out. For example, here’s my target asset allocation according to Personal Capital:

Once you know how assets are allocated, choosing an index fund is fairly straightforward. You just need to find the specific fund names that fit the asset class you want. (If this seems like too much work, you can always choose a lazy portfolio with pre-selected fund proposals.) Here’s how it works.

First, look at the Asset Class category in the above example. This tells me the general classes I need to invest in: international stocks, US stocks, international bonds, and more. Let’s focus on choosing index funds for US stocks.

To find funds for this class or category, I need to search for a list of index funds at my brokerage firm. I use Vanguard, and here is the list of Vanguard funds . From there, I simply run a search for index funds that fit into the class I want, which is again US stocks. They are here:

There are several different indices that fall into this class: large cap , small cap, and so on. The more you learn about investing, the more accurate your portfolio will be in each of these subcategories. But for now, you only need one or two basic rules to get started. In my scenario, I selected the VTSAX and VFIAX index funds. When I was referring to these specific funds, I was researching a couple of important things.

First, make sure your spending ratio is good to low. This is as it should be if it’s an index fund. According to Motley Fool , an index fund’s typical expense ratio is around 0.25%. As you can see in the example above, only one of them reaches 0.10%. Vanguard’s expense ratios are notoriously low.

Also, make sure the fund is actually tracking its index. Compare the performance history of a fund with the index it tracks. They should be fairly parallel. For example, here’s how close the VFIAX is to the S&P 500:

Once you’ve selected and researched your find, it’s time to buy it. Go to “Buy” from your investment account and enter the required information. You are likely to be asked where the money will come from (from your bank or other investment account) and what you want to buy (name of the index fund). You can also just call your brokerage firm and tell them how much funds you want to buy.

Index funds are the perfect solution for building your own lightweight investment portfolio. Yes, you will want to rebalance your portfolio from time to time, and yes, it does take a little money to get started, but overall this is the best investment without user intervention. You can expect ups and downs, but over time you will see your investment grow into a cute little nest.

Illustration by Fruzina Kuhari.

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