“By periodically investing in an index fund the know-nothing investor can actually outperform most investment professionals.” – Warren Buffett.
If you were to ask Warren Buffett (arguably the greatest investor of all time) what you should invest in, he would suggest that you buy index funds. He has also instructed his estate’s trustees to put his heirs’ proceeds into index funds when he dies. Why?
Because if you build a diversified portfolio of low-cost index funds, you will beat about 90% of professional investors over the long-term. The best part – you don’t need to be a Wall-street finance wizard and you won’t spend a lot of time managing your investments.
So, what is index investing, anyway?
What is index fund investing?
Before I talk about index fund investing, let’s understand what an index is. An index measures the performance of a large group of assets of similar types (such as stocks, bonds, currencies, or commodities). In the United States, the two major stock market indexes are the S&P 500 and Dow Jones Industrial Average.
The Standard & Poor’s 500 Index
The Standard & Poor’s 500 Index contains 500 of the top companies in the U.S. Stocks are usually included in the index based on its market capitalization (number of shares outstanding times the share price), but the constituent committee also considers factors like liquidity, financial viability, trading history, etc.
Surprising fact: did you know that Tesla is not part of the S&P 500 yet because of its shaky financial past? The company is expected to break into the index by the end of 2020/early 2021.
Overall, the S&P 500 is a good indication of the state of the U.S. stock market because it represents around 80% of the total value of the U.S. stock market.
The Dow Jones Industrial Average
The Dow Jones Industrial Average (DJIA) is one of the oldest indexes in the world. It includes the stocks of 30 of the largest and most influential companies in the United States.
An index fund
An index fund is a type of mutual fund or exchange-traded fund that is designed to track the performance of a specific index or a market. For example, if the index tracks the S&P 500, the fund buys shares from every company listed on the index. An investor, in turn, can buy shares of the index fund, whose value will mirror the gains and losses of the index being tracked. Also, the investor could buy an index fund tracking the performance of the total U.S. stock market or international stock markets.
Index investing is considered a passive investment strategy because instead of trying to outperform the market by picking individual stocks or timing it, passive investors simply look to match the market returns.
Not excited about getting market returns? Think again. Since 1926, the market has on average returned 9.7% a year! 10-year government bonds have returned an average of 4.9%. In contrast, the average interest rate on most savings accounts is 0.09% (according to FDIC). I’ll take average market returns all day long. That’s why you need to start investing right now!
Three major benefits of index investing
Index investing offers a lot of advantages, especially for beginner investors and people starting out with little investment capital. The following three are major benefits of index investing: diversification, low fees, and simplicity.
We diversify to lower our portfolio’s risk because markets are unpredictable. When you buy shares of a single index fund, you gain access to an investment portfolio made up of a very large number of securities. The time and expense to build and maintain a similar portfolio yourself would likely be prohibitive.
For example, I own VTI – an exchange-traded fund created by Vanguard that tracks the performance of the U.S. Total Market Index. For $160/share (current market price of VTI) I get exposure to 1585 U.S. publicly traded companies!
As an investor, you cannot control the markets, but you can control what you pay to invest. And that will make an enormous difference over time. The lower your costs, the greater your share of an investment’s return, and the greater the potential impact of compounding.
In investing there is no reason to assume that you get more if you pay more. Instead, every dollar paid for management fees, trading commissions or taxes is simply a dollar less earning potential return.
Because index funds are “passive” investment vehicles, they don’t require the fund manager to do much work to keep them running. So, index funds generally have much lower fees compared to actively managed mutual funds.
For example, I pay a net expense ratio of 0.03% for my VTI holding. Compare that with +1% charged by actively managed mutual funds! According to Vanguard, a 1% management fee will cost you 25.8% of your investment over 30 years (compared to 3% of your investment for a management fee of 0.1%). That’s more than a quarter of your portfolio! I don’t think so…
Index investing allows you to come up with a simple investment plan that is easy to implement and easy to stick to over the long-term. Being consistent and sticking to your plan is key in successful long-term investing.
Nobody has time to constantly watch the market, analyze companies’ financial statements, and worry about your portfolio every day. Index investing lets you automate your investing, so you build wealth while you’re busy living your life.
Limitations of index investing
Passively managed index funds do not attempt to beat the market. They seek to match the overall risk and return of the market. For some people getting an average market return is not good enough. I wish them best of luck!
A lot of research suggests that over long-term horizons passive investments outperform actively managed funds after taking into account taxes and fees. However, the argument could be made that over shorter timespans, some active mutual funds might do better.
Some investors might argue that index funds are not very flexible. What’s inside the index fund is not up for debate. My response to that – that’s the whole point! If I buy an index fund, I do NOT want to be picking any individual securities myself.
Index funds vs. ETFs
Before we dive into the index fund investing strategies, let’s look at the distinction between an index fund and an ETF (exchange-traded fund). They differ in three main ways:
Anyone buying an index fund can place an order to purchase such a fund. They pay the closing price at the end of the trading day. ETFs are different. They trade on a stock exchange, much like individual stocks. If you place an order to buy an ETF, you pay the price at the time of your execution, not the end of the day.
ETFs are often slightly cheaper than index funds if bought commission-free. Index funds often have higher minimum investments than ETFs
3. Reinvestment of dividends
When an ETF receives dividends, they may or may not be reinvested automatically for free. It depends on the brokerage firm you use. With traditional index funds, however, dividends can be reinvested automatically at no extra cost.
Basically, if you are a long-term investor, the difference between owning an index fund or an ETF should not be material.
Index fund investing strategies
Index fund investing strategies differ in a way that you do your asset allocation. Asset allocation is diversification across asset classes. It is a mix of different types of investments you hold in your portfolio – stocks, bonds, real estate, and other investments.
Strategy #1: Create an asset allocation using low-cost index funds/ETFs
Asset allocation is the most important decision you’re going to make. The Portfolio’s proportions of stocks, bonds, and other investments determine 91% of its returns as well as its volatility (security selection and market timing are responsible for the other 9%).
You can pick your own asset allocation, get help from a financial advisor, or use services of online Robo-advisor that will create an asset allocation based on the information you provide. I am a big fan of Ellevest!
If you’re a DIY type of gal like me, I highly recommend utilizing a “couch potato” portfolio: you split 100% of your money between three index funds/ETFs: one representing the U.S. total stock market, one representing the U.S. bond market, and one representing the international stock market.
The asset allocation decision is one of the cornerstones for achieving your investment goals. But it only works if the allocation is adhered to overtime through the ups and downs of the market. Periodic rebalancing is necessary to bring the portfolio back into line with original asset allocation.
Check your asset allocation annually or semiannually and rebalance your portfolio if it has deviated more than 5% from the target. I personally rebalance my portfolio once a month and it only takes me a couple of minutes. If you’re using Ellevest, they will rebalance your portfolio automatically for you.
Strategy #2: Buy Target Date Index Funds
But what if you’re one of those people who knows you’ll just never get around to figuring out appropriate asset allocation and which index funds to buy? Many people don’t want to construct a diversified portfolio and they certainly don’t want to rebalance their funds, even if it’s just once a year. If you fall into this group, your solution is Target Date Funds.
Target Date Funds are simple funds that automatically diversify your investments for you based on the year you plan to retire. They automatically pick a blend of investments for you based on your retirement year and rebalance your portfolio periodically.
They start you off with aggressive investments (more stocks, fewer bonds) and become more conservative as you get older. Not all Target Date Funds are created equal. You have to look under the hood and see how the asset allocation changes over time. But as a general rule, they are low cost and tax-efficient worry-free investments. All you have to do is to periodically contribute more money to your investment account and watch it grow over time.
How do index funds/ETFs make money?
So, how do index funds/ETFs make you money, exactly? Good question. Any investment makes you money in three ways:
- When the value of your investment goes up
- When you get paid because you own the investment
- The money you’ve made can be reinvested to make more money
You can make money when your investment goes up in value. For example, if I’ve purchased 1 share of VTI on 03/16/2020 for $121 and sold it today for $160, I’ve just made $39.
You can also make money by receiving payments because you own an investment. The owners of stocks will receive payments that are called dividends. If you own bonds, you get paid coupons (or interest payments). For example, for owning the shares of VTI I have collected a dividend payment of $193 at the end of 2Q2020.
Lastly, you make money from compounding interest. This is how it works: when you invest your money, it hopefully earns returns, and then the returns you’ve earned can be reinvested and also earn returns of their own.
Which ETFs are in my portfolio?
I am a big fan of simplicity. That’s why I designed my portfolio asset allocation based on a “couch potato” portfolio model, with one small change.
I am a firm believer that we can make a positive change in the world by ESG investing. I vote with my dollars for the companies that are trying to do good while also making money. That’s why I allocated a part of my U.S. stock portion to the ETF that invests in ESG compliant companies.
Here is a list of ETFs I own in my personal investment account:
VTI – Vanguard Total Stock Market ETF. It represents U.S. total stock market
ESGV – Vanguard ESG U.S. Stock Market ETF. It represents U.S. companies compliant with ESG standards.
VXUS – Vanguard Total International Stock Index Fund. It represents the international (excluding the U.S.) total stock market.
BND – Vanguard Total Bond Market Index Fund. It gives me exposure to both U.S. government bonds and bonds of top-rated U.S. companies.
Books to read about index investing
If you would like to learn more about index investing, there are two easy reads that I highly recommend.
One is written by John Bogle, the father of index investing and founder of Vanguard. In his book, Mr. Bogle describes the simplest and most effective investment strategy for building wealth over the long term.
The other one is written by “Bogleheads” – true fans of John Bogle’s investment philosophy. This book describes an all-indexed portfolio that contains over 15,000 worldwide securities, in just three easily-managed funds, that has outperformed the vast majority of both professional and amateur investors.