We’ve all heard the stories of how people invested some money, the stock took off, and now they’re mega-rich living the high life. This has happened recently with many cryptocurrency investors. The less glamorous story happens much more often: someone bought a stock that was a “sure thing”, invested a lot of money into it, and lost a lot of money. This has also happened recently with many cryptocurrency investors. Instead of looking at investment options that will drive such extreme results, we’re going to focus on a more balanced, less risky way to start investing: index funds.
Although index funds may not create headline-making returns, they are the primary investment vehicle I used to reach financial freedom at age 34, and I’m not alone. Do a little research on reaching financial independence and nearly everyone will tell you about index funds. JL Collins, among others, wrote an entire book about it.
Here I’ll share with you how to start investing in index funds and how to select one. We’ll discuss cost considerations of expense ratios and minimum investment requirements. I’ll also share the fund I invest in and the investment company I use.
What is an Index Fund?
NerdWallet defines an index funds as “a type of mutual fund whose holdings match or track a particular market index.” Ok, but what does that mean? In its simplest form, an index fund is a collection of all of the stocks that make up an entire market. So instead of picking a single stock and hoping it does well, an index fund selects every stock.
Think about it this way. You can either invest in Apple or Microsoft, or you can invest in both. If Microsoft stumbles and Apple soars, Apple’s stock price will grow and Microsoft’s stock price will decrease. If you invested solely in Microsoft, your investment is worth less than when you bought it. But if you invested in both companies, Apple’s gain would help offset Microsoft’s loss. Index funds often have companies that span multiple industries to further offset risk. This is called “differentiation”. The more companies and industries in a fund, the more risk-tolerant the index fund.
Cost consideration: Expense Ratios
Expense ratios are the fees you pay for the overall management and administration of the index fund. Because we’re amateurs who are mostly taking an educated guess at investing, we pay the professionals who take care of all of this on our behalf.
A higher expense ratio does not equate to better index fund management or better returns. Look for expense ratios that are low, as this will be a reoccurring fee for the life of your investment. They are paid automatically through your investment account, so no need to worry about another bill to keep track of.
Cost consideration: Minimum Investment
The second consideration for choosing an index fund is the minimum investment required to open the fund. These can range from hundreds to tens of thousands of dollars. There is no guarantee that a bigger initial investment will get you better returns. As such, look for a fund that has an attainable minimum investment requirement and a low expense ratio.
Out of the two of these, a low expense ratio is more important because it’s a reoccurring expense. However, each person’s financial position is a little different, and a minimum investment can be challenging to come up with. If you really want to start investing, don’t compromise from the beginning by selecting a fund only because the minimum is low. Save your pesos to meet the minimum of your desired fund. If you aren’t disciplined enough to budget for your initial investment, then you should be looking for other advice right now.
Recommended Index Fund: VFIAX
Most people who invest in index funds choose Vanguard funds. Vanguard founder Jack Bogle invented the index fund way back in 1976 and Vanguard has been the industry leader ever since. Offering the lowest fees in the industry, Vanguard funds return the greatest value to investors.
The fund I invest in is Vanguard’s VFIAX index fund. The VFIAX index fund has stock from 511 of the U.S.’s largest companies across 11 industries. It has a minimum investment requirement of $3000 and an expense ratio of 0.04%. I’ve been investing in this fund for nearly a decade and my gains are akin to Vanguard’s hypothetical growth of a $10,000 investment 10 years ago.
While this chart is hypothetical, it is a historical view using actual market figures. So if you invested $10,000 in this fund in October 2009, your $10,000 investment would be about $35,000 in October 2019. Keep in mind this timeframe is when the recession began to recover, so they are abnormally high. You should not expect your investment to triple every 10 years. A general rule of thumb is that your investment will double every 10 years, which is still a very good return!
If you decide to invest in an index fund, be sure to look at the cost considerations listed above, and the companies and industries that comprise a fund. If you look at all of this and it still muddles your mind, engage a financial planner for advice. An hour or two with a financial planner will pay off quickly.