For many people, investing money can seem like this deep dark super complicated world that is just too difficult to understand. But just like with anything learnable in life, with a little effort, you can learn how to invest. And the good news is that investing does not have to be as complex as it sounds especially if you consider investing via index funds, one of my favorite ways to invest money.
If you are serious about building wealth and growing your money, you are going to need to do more than just save money in a bank account (especially given today's interest rates compared to the rate of inflation). Investing is one way in which you can grow your money. In this post, I'm going to talk about indexes and index funds and why investing doesn't need to be so complex.
So let's start with some simple definitions.
What is a stock market index?
In very simple terms, a stock market index is basically the measure of change of the value of the stock market or a segment of the stock market. Examples of very popular indexes you may have heard of if you live in the United States include:
The Dow Jones Industrial Average (DJIA)
An index that tracks the 30 largest and most influential companies in the USA.
The S&P 500 (Standard & Poor's 500)
An index that tracks the market capitalizations of 500 large companies that have common stock listed on the NYSE (New York Stock Exchange) or the NASDAQ ( National Association of Securities Dealers - Also a stock exchange market and 2nd largest in the world after the NYSE).
Other indexes include ones that measure the overall/entire stock market, specific industry sectors or segments of the stock market, the international stock market, the bond market (the market around credit and debt), etc.
Next, let's talk about index funds.
What is an index fund?
"By Investopedia's definition, an index fund is a type of mutual fund with a portfolio constructed to match or track the components of a market index, such as the Standard & Poor's 500 Index".
In plain English, this means, an index fund can be set up to buy all the same stocks within a specific index like say the S&P 500; this means you will be invested in every single one of the 500 companies that make up the S&P 500.
Or you can purchase a total market index fund which invests your money in equal ratios across the entire stock market based on a total market index that measures the investment return of the overall stock market.
The key difference between an index fund and a mutual fund is that while an index fund simply tracks indexes (as described above), a mutual fund is based on stock holdings that are selected by a portfolio manager or fund manager who actively manages the mutual fund and charges you a fee for doing so.
So what are the benefits of index funds?
1. Index funds have low expense ratios
Index funds are not actively managed by a portfolio manager or fund manager and so, as a result, they are no high annual fees passed on to investors.
Most index funds have really low expense ratios of less than 0.05% of the fund's assets (paid to brokerage firms) which means you keep more of your returns in your pocket which can grow towards your retirement.
2. You are not trying to outperform the stock market
Outperforming the stock market is the goal and promise that many fund managers make with the funds they select and manage.
With index funds, you know what you are getting as you are simply tracking an index, so if the index rises 10% then your index fund will also rise 10% if the index declines 5%, then your index fund will also decline 5%.
Why is this a benefit? Well, based on a study done by Standard and Poors , "The majority of managers underperformed the benchmark". The study shows a mutual fund that promises to outperform the stock market has a high chance of underperforming. Wouldn't you rather know what you are getting?
3. You get a wide array of diversification
By investing in a US total market index fund your money is invested across the entire US stock market. Now, how's that for diversification?
What kind of index funds can you invest in?
You can pretty much cover all your bases by splitting your money 3 ways across index funds that cover the following and then rebalance your portfolio over-time to keep your money equally split:
- The U.S stock market
- The U.S bond market
- The International stock market
Where can you buy them?
My top two favorite brokerages are Vanguard and Fidelity due to their super low fees and super customer service (purely my personal opinion).
What about index investing in my retirement accounts?
You can invest in index funds in your personal IRA if you have one or if you are self-employed but index funds may not always be offered in employer-sponsored retirement plans. Does this mean you should not invest? Absolutely not. Do your research and take the best option offered to you and most certainly do not miss out on your employer match if one exists.
Before you make any investments, you want to do your own research and make sure you are fully understand anything you are investing in. You also want to keep in mind that investing is not a gamble but is a long-term wealth-building strategy.
Do you invest in index funds? Share your thoughts!
Note: This post in no way implies that mutual funds are bad or that they do not outperform the stock market. Many mutual funds do. This post discusses index funds as one of many ways to invest in the stock market and like I always say - do your research.