We may receive compensation from companies mentioned within this post via affiliate links. Read our full advertiser disclosure. Opinions, reviews, analyses & recommendations are the author’s alone, and have not been reviewed, endorsed or approved by any of these entities.
273 Shares
In August, for the first time ever, there was more money in passive index funds than in actively managed funds.
I think this is a good trend, as I practically beg new investors to keep it simple.
The easiest way to keep it simple is by not investing in individual stocks. There are also way too many investors getting ripped off by the high fees that come with actively managed funds, a majority of which do not outperform a passive index over the long-term.
To new investors this jargon can be confusing.
I was telling a friend recently about index funds, and I got a blank stare. He jokingly said, “index cards? Is that what you are talking about?”
Investing can be intimidating because of how some people over-complicate it. If you watch “Made Money” you would think stock picking is something everyone should be doing. In reality, most investors – and certainly new investors – would benefit from focusing on low-cost index funds that track the broad stock market.
Let’s start by answering the question: what is an index fund?
Index Funds Explained
Index funds are mutual funds or Exchange-Traded Funds (ETFs) set up to track the performance of a benchmark index, such as the S&P 500. Said differently, they move up or down in price based on a large basket of stocks. This is beneficial because you spread your exposure across many companies. Compare that to investing in only a handful of individual companies. If one of those companies failed and went bankrupt, a large portion of your investment portfolio would be wiped out. With an index fund exposure is spread out across many, many companies, reducing your exposure and risk related to any one company.
Many index funds are capitalization weighted, or cap-weighted, which means that the larger components are given a larger weighting. For example, if you look at the Fidelity total stock market index fund you will see that the top holdings are, among other large companies, Microsoft, Apple, Amazon, and Facebook. The reason they make up a higher percentage than say, a small company whose market capitalization is only $10 million, is because having the same exposure to Apple as a $10 million company would give too much exposure to the small company.
Index funds are passively managed, meaning there is not a fund manager trying to “beat the market.” This allows the funds to have low fees, sometimes as low as 0.00% (for example, Fidelity’s total stock market index fund FZROX). The problem with actively managed funds is that they not only have to beat a benchmark index, but they also have to beat the index plus the fee they charge, which can be as much as 2% or more.
Here are a few examples of index funds. Notice the low fees charged.
Fidelity ZERO Total Market Index Fund (FZROX)
Objective (from the Fidelity website): The fund seeks to provide investment results that correspond to the total return of a broad range of U.S. stocks.
ETF or Mutual Fund: Mutual Fund
Expense Ratio (Fees): 0.00%
Minimum Investment: $0
Vanguard Total Stock Market Index Fund Admiral Shares (VTSAX)
Objective (from the Vanguard website): Designed to provide investors with exposure to the entire U.S. equity market, including small-, mid-, and large-cap growth and value stocks..
ETF or Mutual Fund: Mutual Fund
Expense Ratio (Fees): 0.04%
Minimum Investment: $3,000
Vanguard Total Stock Market ETF (VTI)
Objective (from the Vanguard website): Vanguard Total Stock Market ETF is an exchange-traded share class of Vanguard Total Stock Market Index Fund, which employs an indexing investment approach designed to track the performance of the CRSP US Total Market Index, which represents approximately 100% of the investable U.S. stock market and includes large-, mid-, small-, and micro-cap stocks regularly traded on the New York Stock Exchange and Nasdaq.
ETF or Mutual Fund: Mutual Fund
Expense Ratio (Fees): 0.03%
Minimum Investment: Cost of 1 Share is approximately $150
You can find a lot of index fund options at both Vanguard and Fidelity. Vanguard has made a name for itself in the low-fee index fund space, and many investors use them. Fidelity has recently rolled out more options for index fund investing as well.
Resources and Tools for New Investors
To invest you need positive cash flow that can be diverted to index funds. I wrote a post outlining 5 ways to find cash to invest in the stock market that may be helpful if one of your goals is to invest more.
I also created a spreadsheet you can use to quickly and easily analyze your 401k or 403b investment options. You can grab a free copy here.
Bottom line on index funds: Index funds offer investors the benefit of low fees and lower risk due to broad exposure to the market.
An index fund is a type of mutual fund or exchange-traded fund that aims to mimic the performance of an index, such as the S&P 500®. Index funds tend to offer investors lower costs and taxes than some other types of funds. They're also relatively lower maintenance.
Key Takeaways. An index fund is a portfolio of stocks or bonds designed to mimic the composition and performance of a financial market index. Mutual funds and exchange-traded funds (ETFs) have many different varieties of low-cost index funds. They have lower expenses and fees than actively managed funds.
Index funds are popular with investors because they promise ownership of a wide variety of stocks, greater diversification and lower risk – usually all at a low cost. That's why many investors, especially beginners, find index funds to be superior investments to individual stocks.
Index funds are investment funds that follow a benchmark index, such as the S&P 500 or the Nasdaq 100. When you put money in an index fund, that cash is then used to invest in all the companies that make up the particular index, which gives you a more diverse portfolio than if you were buying individual stocks.
The benefits of index investing include low cost, requires little financial knowledge, convenience, and provides diversification. Disadvantages include the lack of downside protection, no choice in index composition, and it cannot beat the market (by definition).
You can either open an account with the broker that offers the fund you want, or you can simply open an account with your preferred broker. Many of the major brokers offer their own index funds but they tend to largely track the major indices, so performance should be similar across brokers.
Investing in an index fund, such as one that tracks the S&P 500, will give you the upside when the market is doing well, but also leaves you completely vulnerable to the downside.
However, an index fund does not have that flexibility as it has to be fully invested in the index at all points of time. While index funds are free from the fund manager bias, they are still vulnerable to the risk of tracking error. It is the extent to which the index fund does not track the index.
According to Standard and Poor's, the average annualized return of the S&P index, which later became the S&P 500, from 1926 to 2020 was 10%. 1 At 10%, you could double your initial investment every seven years (72 divided by 10).
As with other mutual funds, when you buy shares in an index fund you're pooling your money with other investors. The pool of money is used to purchase a portfolio of assets that duplicates the performance of the target index. Dividends, interest and capital gains are paid out to investors regularly.
If you're new to investing, you can absolutely start off by buying index funds alone as you learn more about how to choose the right stocks. But as your knowledge grows, you may want to branch out and add different companies to your portfolio that you feel align well with your personal risk tolerance and goals.
The S&P 500 is all US-domiciled companies that over the last ~40 years have accounted for ~50% of all global stocks. By just owning the S&P 500 you miss out on almost half of the global opportunity set which is another ~10,000 public companies.
As with other mutual funds, when you buy shares in an index fund you're pooling your money with other investors. The pool of money is used to purchase a portfolio of assets that duplicates the performance of the target index. Dividends, interest and capital gains are paid out to investors regularly.
Most index funds pay dividends to their shareholders. Since the index fund tracks a specific index in the market (like the S&P 500), the index fund will also contain a proportionate amount of investments in stocks. For index funds that distribute dividends, many pay them out quarterly or annually.
The 4% rule says people should withdraw 4% of their retirement funds in the first year after retiring and take that dollar amount, adjusted for inflation, every year after. The rule seeks to establish a steady and safe income stream that will meet a retiree's current and future financial needs.
Index funds are a low-cost way to invest, provide better returns than most fund managers, and help investors to achieve their goals more consistently. On the other hand, many indexes put too much weight on large-cap stocks and lack the flexibility of managed funds.
Introduction: My name is Van Hayes, I am a thankful, friendly, smiling, calm, powerful, fine, enthusiastic person who loves writing and wants to share my knowledge and understanding with you.
We notice you're using an ad blocker
Without advertising income, we can't keep making this site awesome for you.
In August, for the first time ever, there was more money in passive index funds than in actively managed funds.
