When I first became interested in investing 20 years ago, investing in individual stocks and actively managed mutual funds dominated financial magazines and television.
These days, however, more and more investors are choosing to invest in passively-managed index funds.
If you’re new to the world of investing, here are ten things you should know about index funds:
1. With index investing, you beat the vast majority of investors.
Index investing isn’t exciting. When you invest in index funds, you get the market return. No more, no less.
Many new investors think they have to do more in order to beat the market. They think that the more they study the market, the better they will do. Unfortunately, the average investor underperforms the market, often by a wide margin.
Simply by achieving market returns, you end up doing better than the majority of your fellow investors.
2. It is significantly cheaper to invest in index funds than actively-managed mutual funds.
When you invest in an actively-managed mutual fund, you’re paying for the salary of the fund manager and his research team. Unfortunately, the vast majority of actively-managed mutual funds are unable to beat the market despite all of the money they spend on research.
With index funds, you only pay for the transaction costs of running the index funds; this requires fewer staff and resources.
The best index funds charge less than 0.10% per year in management fees. Actively-managed mutual funds can charge 10x that amount to manage your money.
3. Index funds are more diversified than a portfolio of individual stocks.
Index investing can be boring. You don’t get to try to find the next Amazon or Starbucks stock.
But index funds, which can hold thousands of stocks within a single mutual fund, are more diversified than a portfolio of 10 or 20 individual stocks.
You don’t want to put all your eggs in one basket, and index funds ensure that your portfolio won’t get significantly hurt by the performance of any one single company.
4. You can build a diversified portfolio with a single target-date index fund.
Investing in index funds doesn’t have to be complicated.
You can get a diversified portfolio across domestic stocks, international stocks, and bonds with a single target-date index fund. Vanguard, Fidelity, and Schwab each have a full offering of target-date index funds.
Simply pick your target retirement date (or a little earlier if you want to invest more conservatively) and put all of your money in that target-date fund. The fund will automatically rebalance your portfolio and become more conservative in its asset allocation over time. You can buy target-date index funds and pay around $15 in management fees per year for every $10,000 invested.
5. Target-date funds do not necessarily hold index funds
If you choose to invest in target-date funds, look carefully to make sure that the fund is investing in index funds. There are many target-date funds that invest in expensive, actively-managed funds.
The easiest way to figure out whether a target-date fund invests in index funds or actively-managed funds is by looking at its expense ratio. An expense ratio of less than 0.20% means that the target-date fund probably invests in index funds.
6. Creating a customized index fund portfolio is simple and often cheaper than a target-date fund.
If you want to customize your asset allocation to your personal risk preferences, it’s easy to buy a portfolio of 2-5 index funds, and this can be cheaper than buying a target-date fund.
I personally use a three-fund portfolio, consisting of a U.S. stock fund, an international stock fund, and a U.S. bond fund.
Deciding the exact allocation of bonds vs. stocks or U.S. versus international stocks is a personal decision, but you can’t go significantly wrong by simply replicating the asset allocation of a target-date fund.
7. Not all index funds are cheap
The index fund industry has consolidated to a few big players. Many other fund companies offer index funds, but they often will charge higher management fees.
Stick with Vanguard, Fidelity, Schwab, and Blackrock (iShares) for your index fund investing – these are the market leaders in the industry.
8. Invest in ETFs for taxable accounts (unless you are at Vanguard).
A quirk in the tax code makes exchange-traded funds (ETFs) more tax-efficient than mutual fund versions of index funds.
Mutual funds have to pay out capital gains distributions (which are taxed) while ETFs do not. As a result, it is slightly more tax-efficient to invest in ETFs within taxable accounts. You can invest in either mutual funds or ETFs in tax-advantaged accounts.
The important exception to this rule is Vanguard, which structures their mutual funds like ETFs.
9. You will need to periodically rebalance your portfolio.
If you choose to invest in a portfolio of index funds, your allocation between stocks, bonds, and other asset classes changes as the market moves up and down.
As a result, you should periodically rebalance your portfolios to reset it back to your desired asset allocation.
10. Minimize trading in your taxable accounts, and don’t use index funds as a vehicle to time the market.
It is easy to get caught up in the ups and downs of the market.
Reading the news can scare you in a down market. Or it can make you greedy in an up market. Either way, some investors are lured into believing that they can sell at market highs and buy at market lows. Unfortunately, this is much easier said than done. Those who try tend to end up with significantly lower returns, primarily because their money doesn’t spend enough time being invested in the market.
What do you think? Do you have any index fund investing tips or tricks to share with your fellow investors?
Good stuff, WSP.
One more note on most target date funds that I have seen is that they lean a little more heavily towards international markets than some might prefer. For example, many of the life cycle target date funds at Vanguard have close to 40% international index funds… That’s a lot more than I want.
This, of course, might be made up for the hands off approach and the auto-rebalancing vanguard will do for you… But just thought I’d mention it.
TPP
Remember that market weight is 50% domestic / 50% international. Few people I know actually use that allocation (perhaps because international hasn’t done as well as U.S.), but if someone wants to use a Vanguard target-date fund, they’re not likely to be quibbling over 10-15% differences in international stock allocation.
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Good stuff WSP. When I started investing index funds and ETFs did not exist. I really believe that this “revolution” has made it easy to become wealthy if you close to follow your 10 tips.
It existed, but certainly not in the way it is today.
That is an interesting point about ETFs being more tax efficient in everyone’s offerings except Vanguard (I did not know this but luckily I am in Vanguard so it is a moot point for me).
I try to do ETFs whenever I cannot qualify for the lower admiral share expense ratios which ETFs appear to have the equivalent. The only pain with investing with ETFs is you have to buy whole shares so if you have a certain amount of money, there is often money left over whereas I can deploy the whole amount with a mutual fund.
I do have a question. With personal Capital I am able to see the asset allocation of each investment vehicle. I am all in on index fund investing in these vehicles but have noticed that the cash balance has been a lot larger than I expected (some are in the 5-6k range. Is that typical? I would think that with index funds there would be little as a cash equivalent because it would be deployed in the market (my theory is that this may represent all the cash holdings from all the individual stocks)
We can’t hear this message too many times. I think the biggest obstacle that physicians have with investing “passively” in “index funds” is they don’t like to be “average.” Most see themselves as above average in many ways, especially with intelligence and ability to read, analyze and learn. So it only makes sense that they shouldn’t settle for “average” investments. They want to outperform. Eventually, some understand that to outperform and be in the top 15% of after-tax, after-cost the most predictable way to get there is -ironically- those “average, passive” index funds.
It’s kind of like telling medical students that all they need is First Aid and USMLE World to crush Step 1. They think they need to add this supplemental cource or that “secret” resource that none of the other medical students have. In investing, as in Step 1, stick with the basics and you will go far.
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I just had some friends over last night from medical school. Half had no interest to learn anything about investing and the other half was split between passive index fund investing and going rogue with Robinhood in order to “be more aggressive.”
I could sense my friend recoiling when I said a good S&P fund will give the market returns. Like Crispy said, he wanted to beat that average!
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Eventually, I hope that when new residents think about investing, the first thing that comes to their minds are “index funds”. It certainly wasn’t that way when I first started learning about finance.
The book “The Richest Man In Babylon” explains the 10% principle very well.
This and two more principles, re-balancing and dollar cost averaging. Very powerful.
I’m applying this principles in cryptos as well. Seems like where there’s uncertainty and hate in certain investment vehicles, is where my money is going. I’ve been holding off in paper assets lately, paused my 401k after a month of activation at 5% ($0 lol), now with global and foreign financial affairs, and a reduction of real estate sales nationally, will have to reconsider how to profit from future impending “crash” if any, whether it be put options or Inverse ETF’s, but then, I’m over-speculating :).
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