I don’t know about you, but despite my repeated attempts to fully understand and grasp how investing in the stock market works, I’m still pretty clueless. I fancy myself a moderately intelligent, business savvy guy, so I would think I’d be able to wrap my mind around this stuff, but I can’t. And honestly, investing is so boring to me that I don’t have the willpower to continue trying to understand it. Moreover, I realized at a certain point in my investment research that if I really wanted to be successful, I would need to spend lots of time and energy researching and managing my investment portfolio. In the words of Oklahoma’s own Sweet Brown, “Ain’t nobody got time for that!”
I am what Berkshire Hathaway Vice-Chairman Charlie Munger would call a “know-nothing investor.” According to him, most average folks who invest in the stock market are know-nothing investors. And there’s nothing wrong with that. Most folks don’t have the time or resources to be know-something investors. In fact, according to Munger and other financial whizzes like Warren Buffett and Jack Bogle, know-nothing investors can actually do pretty well in the market. In many cases, they can even outperform professional stock pickers.
It just requires two things: 1) recognizing and embracing the fact that you’re a know-nothing investor and 2) investing in index funds.
I can’t really help you with number 1, but I can point you in the right direction with number 2. Today, we take a look at how to get started with index fund investing.
What Is an Index Fund?
To understand what an index fund is, first we need to know what a stock market index is. A stock market index is a number that refers to the relative value of a group of stocks. As the value of the stocks in a particular index changes, the stock market index’s number changes. If you watch or listen to the news regularly, you’ve heard about stock indexes. Two of the most widely referenced stock market indexes are the S&P 500 and the Dow Jones. Each respective stock market index is made up of different stocks. Both are seen as ways to gauge how the market is performing as a whole.
An index fund is a type of mutual fund (meaning it pools money from a group of investors) with a portfolio that’s constructed to match a particular stock index (like the S&P 500 or the Dow Jones Industrial). So if you buy an index fund that’s tracking the S&P 500, that fund will try to own the stocks in the S&P 500 in the same proportions as they exist in the market. The performance of an index fund tracking the S&P 500 will usually be on par with the performance of that index.
Besides tracking a particular stock market index, index funds can also be constructed to track a particular sector like technology or healthcare.
What’s the Difference Between Index Funds and Traditional Mutual Funds?
“I believe that 98 or 99 percent—maybe more than 99 percent—of people who invest should extensively diversify and not trade. That leads them to an index fund with very low costs.” —Warren Buffett
The biggest difference between index funds and traditional mutual funds is this: mutual funds are actively managed, while index funds aren’t. An actively managed mutual fund has a fund manager who, using his knowledge of the market, selects stocks and tries to time his buying and selling in order to get the best return and beat the market. With index funds, instead of human beings deciding which stocks to include in the fund, a computer tracks the market and rebalances the fund as needed so that it matches the stock market index that it’s following.
Now you might be thinking: “Don’t I want to beat the market? That’s how you make money in stocks, right? So why would I want to invest in index funds as opposed to mutual funds?”
Great question, and the answer is three-fold: 1) with index funds, you’ll generally outperform actively managed funds over the long run, 2) you don’t have to know much about investing to succeed with index funds, and 3) you’ll keep more of your returns with index funds than you would with actively managed funds.
We go into these three benefits in detail below.
3 Benefits of Index Funds
“Most investors, both institutional and individual, will find that the best way to own common stocks is through an index fund that charges minimal fees. Those following this path are sure to beat the net results (after fees and expenses) delivered by the great majority of investment professionals.” –Warren Buffett
1. Over the Long Term, Index Funds Outperform Actively Managed Portfolios
One of the mantras of investing is to keep a diversified portfolio. It reduces risk in a turbulent market. If one stock is performing badly, you’ll have other stocks or bonds that will counter that loss. While actively managed mutual funds are typically well diversified, the research has shown that over the long run, they don’t perform that well. In 2012, only 39% of actively managed funds performed better than their benchmark (a benchmark is a standard that a manager uses to measure their fund against; usually a stock market index like the S&P 500). In A Random Walk Down Wall Street: The Time-Tested Strategy for Successful Investing, Princeton economist Burton G. Malkiel argues that most active fund managers underperform the S&P 500. Some actively managed funds might crush the market some years, but in the long term they’ll likely underperform. And the reason is simple: it’s hard to pick winning stocks and time the market just right on a consistent basis, even for the professionals.
While you won’t dramatically outperform the market with index funds, you won’t dramatically underperform it either. You get an average return. When most actively managed funds underperform the market, being average puts you out on top.
Now let’s be clear — investing in an index fund doesn’t guarantee that you’ll make money or that you won’t lose it. Because index funds track a stock index, you’ll do as well as the stock does in a particular year. For example, if you had money in the Vanguard 500 Index Fund (tracks the S&P 500) in 2009, you would have experienced a huge drop in your balance. But if you kept consistently investing in it, even during the bad times, you would have seen significant return on your investment because the S&P has been on a tear lately. But there’s always a chance the S&P 500 will tank again in the future, tanking your S&P 500 index fund as well.
The key to success with index funds is to play the long game. Consistently invest in index funds, even when the market sours, and in the long run you’ll do alright, because in the long run the market goes up.
2. You Don’t Have to Know Much About Investing
“By periodically investing in an index fund, for example, the know-nothing investor can actually outperform most investment professionals. Paradoxically, when ‘dumb’ money acknowledges its limitations, it ceases to be dumb.” –Charlie Munger
I know there will be some diehard investors out there who will say that index fund investing is just lazy and that you’re missing out on better returns — that you need to actively manage your own portfolio or spend some more time researching fund managers who have a proven record to beat the market (though even if you find that guy, there’s no guarantee he’ll repeat his performance on a consistent basis).
But here’s the rub: to simply have a chance in outperforming the market, you have to put in massive amounts of time and work. You have to eat, sleep, and breathe investing. Like I said at the beginning of the post, I just don’t have the time for that sort of investment in investing, and I think most average guys are in the same boat. And even if you were to spend a bunch of time and money researching stocks or other actively managed mutual funds, there’s a good chance you’re not even going to match the market. Why spend all that time for sub-par results? Personally, I’d rather settle with the average results of index funds and spend more time working on my business or with my family. The funny thing is, by settling for average, know-nothing investors will likely outperform professional stock pickers.
Bottom line: If you don’t know much about investing or economics or simply don’t have time for significant research, index funds are for you.
3. You Keep More of Your Money With Index Funds
“After analyzing the data over many years, I feel confident in reaffirming the warning that I have consistently given to fund investors over the years: Do not allow the tyranny of compounding costs to overwhelm the magic of compounding returns.” —Jack Bogle
Even if an actively managed fund somehow matches or beats an index like the S&P 500, it doesn’t matter because you’re going to lose a huge chunk of money in fees. And by huge, I mean up to 25% of your investment return huge. What the what?!
With index funds, you get to keep more of your money for the following three reasons:
No (or little) sales commissions. When you purchase an actively managed mutual fund, you typically have to pay a sales commission of 4-6% to the brokerage firm. So if you invest $1,000 into an actively managed fund, the firm is going to take $60 (assuming a 6% sales fee) before your money even gets invested. Now that might not seem like much, but it adds up pretty darn fast after multiple purchases. The brokerage firm selling you the fund will tell you that the commission fee pays for the wisdom and guidance of the fund manager. But as we saw above, most fund managers underperform the market!
Because index funds are set to track a particular stock market index, there’s no need to pay for “expertise” and thus no need to pay a sales commission. When you invest in an index fund, more of your money goes towards your investment and not towards some broker’s country club membership.
Low operating expenses. In addition to the 4-6% haircut actively managed funds give you when you make a fund purchase, each year they’ll deduct 1-2% of the balance of your fund to pay the fund manager and other expenses. This is called the expense ratio. 1% deducted from your fund’s balance each year might not seem like much, but over time it adds up. For example, let’s say you invest $10,000 into an actively managed fund that has a 1% yearly expense ratio. The fund gains 10% each year and you don’t touch the money for 20 years. If you didn’t have to pay the yearly expense fee, you would have had $67,275 after 20 years. But because you had 1% deducted from your balance each of those 20 years, you actually end up with just $56,100. $11,175 of your return (or 16.6%) ended up on in the broker’s pocket. Yeesh.
Because an index fund isn’t managed by a human being, operating costs are significantly lower. Most index funds have expense ratios that are less than .5% and some are less than .2%. The index fund that I invest in has an expense ratio of .18%. If you had an expense ratio of .18% in the example above, you would have only lost $2,168 to operating expenses. Much better than losing $11K.
Tax efficient. Any time you sell a profitable stock, unless they’re held in some sort of tax-free retirement account, you have to pay taxes on that sale, and those taxes can take a real bite out of your returns if you’re not careful. Managers of actively managed funds are regularly selling profitable stocks, and every time they do, a taxable event is created which is passed on to you, the investor.
Because there is generally very little buying and selling within an index fund, tax costs are reduced and you keep more of your money.
How to Get Started With Index Fund Investing
If you want to get started investing with index funds, here are a few things I recommend checking out.
Read up on index fund investing. Don’t just take my word for it. Do your own research. A few books that I found helpful in learning about index funds and investing in general are:
- The Bogleheads’ Guide to Investing. Jack Bogle, the founder of Vanguard and inventor of the index fund, has long been a proponent of index fund investing for the average Joe. Over the years, he’s developed a passionate fan base of investors who like his no-nonsense investing advice. They call themselves Bogleheads, and they have a thriving online community where they discuss investing based on Bogle’s philosophy. The forum and the site in general are awesome. I highly recommend checking it out. The Bogleheads’ Guide to Investing basically encapsulates the main themes you’ll find on the Bogleheads’ site in an easy-to-read book.
- The Little Book of Common Sense Investing. A common sense approach to investing for the know-nothing investor written by Jack Bogle himself. Basically the advice comes down to this: invest for the long term with a diversified portfolio of low cost index funds.
- The Investor’s Manifesto. Another book geared towards the average investor that makes a case for low-cost index fund investing.
Start researching funds. After you’ve done some reading up on index fund investing, start researching specific funds. Over at the Bogleheads’ Wiki, they recommend a three-fund portfolio that consists of a domestic total market index fund, an international total market index fund, and a bond total market index fund. This mixture of domestic and international stock funds as well as bond funds will give a beginner investor plenty of diversity without too much work (which is why the three-fund portfolio is often called the “lazy portfolio”). The Bogleheads also offer suggestions on specific funds for your lazy portfolio from the various brokerage firms. Each fund has different costs and minimum investment requirements. Browse through them and find the ones that are right for you.
For even lazier investing, consider lifecycle funds. When you invest with index funds, it’s often recommended that you invest in several different funds so that you get a comprehensive asset allocation. You don’t want all your money in just equities, like an index fund that tracks the S&P 500. You also want to diversify and have bond funds or real estate funds to offset any downtimes in the stock market. When you’re young, financial experts recommend that you have something like a 90/10 stock/bond asset allocation. As you get older, that asset ratio should shift so that you have less money in stocks and more in conservative investments like bonds and cash.
The problem with asset allocation is that depending on how your investments perform, your allocation can change without you doing anything; for example, your stock fund may go up, while your bond fund goes down, altering the ratio of assets you were aiming for. When that happens, you’re supposed to rebalance your portfolio so you get back to the appropriate asset allocation. That means you may need to sell some bond funds and buy more stock index funds or vice versa.
But let’s be honest. Most people are too lazy to research which index funds should make up their portfolio and/or too lazy to rebalance it every year when it gets out of whack. I know I am.
If you’re looking for even lazier, know-nothing investing, consider checking out lifestyle funds. Also known as target-date funds, these are index funds that have an age appropriate asset allocation of stock index funds and bond index funds. So if you’re a youngin’, a target-date fund will usually have a 90/10 stock/bond fund ratio. As you get older, the target-fund rebalances itself by shifting to more conservative assets. By the time you reach retirement age, your fund will have a 10/90 stock/bond fund ratio. And you didn’t have to do a single thing for that shift to occur. Pretty cool, huh?
Granted, target-date funds aren’t perfect. There are some downsides. You can probably get a better return if you picked and rebalanced your own index fund portfolio. However, like financial expert Ramit Sethi argues in his book, I Will Teach You to be Rich, target-date funds “embody the 85 Percent Solution: not exactly perfect, but easy enough for anyone to get started—and they work just fine.” In other words, good enough for the know-nothing investor.
I’m a big fan of target-date funds. While I have money in other index funds, I have a large amount of my retirement in Vanguard Target Retirement 2045 Fund (VTIVX). I’ve had a 26% return on my investment on it so far. Have I experienced big drops since I’ve invested? Yep. Any time the market as whole went down, the value of the fund went down, too. But it’s always gone back up as the market has recovered. I’m sure I’ll see even more big drops in my portfolio in the years to come. But I’m not going to panic. Again, with index fund investing, you’re playing the long game.
Open up an IRA and start investing. If you want to enjoy even more tax savings, make sure to hold your index funds in a retirement account like an IRA or 401(k).