Primarily, I invest in index funds. I was fascinated and scared of investing when I started learning about personal finance. I didn’t want to lose the money that I worked hard to save. My first experience with stocks went poorly and so I didn’t do any more investing for a great while. But then my aunt (who is very close to retiring early) gave me a copy of The Simple Path to Wealth and my investing mindset changed almost immediately. Here’s a dive into what I’ve learned about index funds and why I’m invested in them.
How are Index Funds like Slow Cookers?
Oh man do I love my slow cooker. I bought it during grad school to save time on cooking and used it often. My work friends can tell you that I talked about my slow cooker soups throughout the fall and winter. In the stock market, index funds exist as a “set it and forget it” type of investment. It’s even easier than using a slow cooker, since you don’t even have to pick the companies in the index. An index fund is a long term investment, where the short term fluctuations in the market don’t matter. Index fund investment relies on the long term consistent growth in the stock market. But what makes this less risky than an individual stock?
Winners and Losers in Index Funds
By holding pieces of every company in the US stock market, an index fund is invested in both winners and losers. Nobody is able to always predict winning companies in individual stocks. Warren Buffet challenged any actively managed fun to beat the S&P500 index over 10 years. Only one took him up on the challenge and lost. As of 2019, index funds had outperformed actively managed funds for 9 years in a row. One of the reasons for this is that cap weighted index funds (like Vanguard’s total stock market index fund), is self cleansing. Simply put, when a company does poorly the index rebalances the portfolio so that the fund owns less of that company. An investor who buys the individual stock of that losing company will simply lose money. In an index fund, the value lost by that company is offset by other companies in the index that are doing well. If a company is successful, the fund will own more of it. By this process, an index funds favors the winners while reducing the effect that the losers have.
Betting on Americans
Index fund investing is an optimistic investment. By investing in a total stock market index fund, I am tying my future retirement to the economic future of the United States. With this investment, I am rooting for the success of other Americans. There’s always uncertainty in the future, but I feel comfortable betting on the innovations and labors of my compatriots. I believe that America is truly unique with welcoming immigrants from all over the world. This isn’t a political stance, just look at all the innovations created by immigrants or their children. The telephone, radio, jeans, and basketball are just a few that we take for granted. Since the recent wave of immigrants is just as hard working and enterprising as the wave that brought my great grandparents here, I trust that American innovation will continue.
Most Indexes are Low Cost
One thing that eats into retirement savings is the expense ratio for the fund you’re invested in. Luckily for index fund investors, the fess associated with index funds are typically lower than actively managed funds. But what difference does one percent make for for your retirement. Let’s look at an example, using a Roth IRA. I’ll assume that you’re maxing out your Roth IRA every year for 40 years until retirement. That’s $6,000 going into your account every year. Now, I’ll use two different expense ratios. Vanguard’s total stock market index fund ETF (meaning you buy it like you would buy a stock, one share at a time) is 0.03%. I’ll compare that to a fund that has an expense ratio of 1%. This example assumes that each is having the exact same return every year of 6%.
These difference is staggering. One percent seems very small, but it ends up costing this hypothetical investor over $200k. Again, this is assuming that the actively managed fund is matching the market and I already pointed out that the vast majority of these funds underperform the market. There’s no reason to pay such a premium for these results.
The Final Argument for Index Funds
It’s just easy. You can spend hours trying to find hot stock tips and researching the finances and outlook of different companies. One of my favorite personal finance bloggers buoys his index fund investment with individual stocks of tech companies that he believes in. Other folks exclusively use index funds to great success (and early retirement). Index funds are not the only investment vehicle available and I’ll try to write about as many as I can in the future. But if you’re new to investing or want to know where to allocate your retirement account funds, index funds are a fantastic option. And personally, that’s where I’m putting the vast majority of my retirement savings.
Disclaimer and further resources:
Frugal Jon is an opinion blog, and I cannot guarantee any stock market returns. If I could, I would not be putting it up for free on the internet.
This article is meant to explain the basics of index funds and why I use them as an investment vehicle. You can learn more about using bond index funds to manage risk here. For a comprehensive stock market description, check out the Stock Series by JL Collins. I’ll return to the subject of risk management and what I do during market downturns in the future.
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