Index Funds Are Oh So Fun! - Dollar After Dollar (2024)

“If you can’t find the needle in the haystack, just buy the haystack.”

This is one of my favorite investment quotes and describes index fund investing so well. You can blow the socks off some of the best mutual funds in existence without ever lifting a finger. In fact, index investing is so easy that you can become a millionaire without ever looking at your portfolio. This may sound like a fairytale, or a magic trick, but you too can be a financial Houdini by understanding a few simple concepts. Now some of you may already be savvy investors, and if you are, then we can virtually pound it because you know what I’m talking about. The problem is that seemingly everyone around me has no idea how to invest. So lets dig in!

What is an Index?

An index is a group of several stocks or other investments that track that markets performance over time. They can come in many different sectors and areas of business, but can also encompass the entire market. Some examples would be the S&P 500, NASDAQ, Russell 2000, Dow Jones, international stocks, bonds, and many other groups of investments. An index fund is a mutual fund that mirrors these indexes so you receive the market returns. Ever wanted to own Apple, Disney, or Nike? Well, when you invest in an index fund, such as an S&P 500 fund, then you are a part owner of these companies.

Diversification

If you’ve ever been at a family dinner or around a group of friends and the topic of investing comes up, what does Grandma always say? “Don’t put all your eggs in one basket”! It’s the oldest investing cliché in the book, but is a good rule to live by for many types of investors. Well if you buy yourself an index fund, you can tell Grandma that you have ALL the baskets and you both can sleep soundly at night. That’s because Index Funds are the most diversified investment vehicles you can get yourself into. You are literally buying the stock market and protecting yourself from any major sector crashes that may occur.

Here’s a snapshot of what you would own if you bought a Total Stock Market Index Fund.

They Beat Mutual Funds

Index funds continue to beat mutual funds year in and year out. Only 20% of actively managed mutual funds actually beat an index fund in any given year, and that is never stable over the long term. Additionally, fund managers actively trade stocks in their mutual funds which leads you to pay the capital gains tax every time they make a trade! I don’t know about you, but I don’t want an MBA toting analyst raising my taxable income.

Fees

Mutual Fund managers charge a fee whether you make money, or lose money. That alone should be very alarming to any financial ninjas like us. The average fee in a mutual fund is about 2%, which most people will look at and say that it’s not a big deal. On the contraire my friend, 2% is a huge deal over time that can result in significant loss to your portfolio, hundreds ofthousands of dollars to be exact. John Bogle (the founder of Vanguard) goes as far as saying that mutual fund fees will eat away at 63% of your portfolio earnings.

Say whaaat? Here’s how he arrives at that conclusion:

The stock market dividend average is 1.9% (About what you earn in the Vanguard Total Stock Market Fund) and your mutual fund manager charges you 1.2% a year. That leaves the investor with 0.7% to reinvest! If someone had one million dollars in a retirement account, their fund would only earn them seven thousand dollars a year! I hope you like eating rice and beans everyday. Just picture an active fund manager as Miley Cyrus, coming in like a wrecking ball on your returns. Nobody wants that. But you don’t have to fear, because index funds are here! Index funds have extremely low fees. How low can they go you ask? Vanguards Total Stock Market Fund (VTSMX) costs 0.17% percent per year (It will actually drop to 0.05% once you hit 10K in your account).

In case you failed kindergarten math:

0.17% < 1.2% (You want to pay other people less money)

Long Term Return

Index investing is a great long-term strategy for your retirement and this is where the fun comes in. If you continue to buy through your working years you can build a significant amount of wealth and reap the fruits of your labor in retirement.

Let’s say you are just graduated college and want to start saving for retirement. You choose to put your money in a Roth IRA (My favorite) and max it out every year ($5,500 annually). You buy the Vanguard Total Stock Market index fund (VTSMX) and fund it when the market is up or down consistently. (You don’t take a year off because of a mid-life crisis, fist pumping, clubbing habit. You stick to it.) Then by the time you retire, you will be a millionaire (An added bonus, with a Roth IRA you won’t pay any additional taxes on this money). This happens through the amazing power of compound interest. You will contribute only ¼ of the money that you retire with, the compound interest does all the rest of the work. Compound interest, you the real MVP.

You can also do this at an accelerated rate by saving more money at a faster pace and stashing it into your 401k, IRA, or taxable account. Many folks from the early retirement community do this at a high success rate. Index funds are one of the top choices for early retirees because they are so reliable. Many have built a million dollar index portfolio in a decade or less. Just search early retirement index investing and a slew of information will pop up.

So to sum it all up:

Vanguard has the best funds around; if you can’t invest there, compare the fee to 0.17%. You will beat the mutual fund average every year and be the most diversified wiz kid in town. Oh yeah, and if you stick to it, a million dollars is in your future. So get that stash flow working before Grandma wacks you with a broom.

Related