The world of investing can seem like a vast, confusing ocean to a newcomer. However, amidst the waves of stocks, bonds, commodities, and complex jargon, there is a beacon of simplicity – low cost index funds. As you embark on your financial journey, understanding the benefits and principles of index fund investing can be a game changer. So, let’s dive into it!
What Is an Index Fund?
In basic terms, an index fund is a type of investment that mirrors a certain market index. Instead of handpicking specific stocks or bonds to buy, you’re essentially buying a small piece of every company or bond in that index.
You might have heard of the S&P 500. It tracks 500 of the biggest U.S. companies. So, when you invest in an S&P 500 index fund, you’re investing in those 500 companies all at once. There are many other indexes like the Dow Jones Industrial Average, Nasdaq Composite, Russell 2000, and so on, each representing different slices of the market.
Index funds can be exchange traded funds (ETFs) or mutual funds. ETFs typically carry lower expenses and can be traded throughout market hours like stocks. You can learn more about ETFs here.
Why Choose Index Funds?
1. Diversification: By holding many different stocks or bonds, index funds spread out the risk. If one company does poorly, the effect on your total investment is minimal because you’re invested in many companies.
2. Low Costs: Index funds are passive, meaning they simply follow a set index and aren’t actively managed. This translates to lower fees, which can save you a lot of money over time.
3. Historical Returns: Over long periods, the stock market, represented by major indexes like the S&P 500, has generally gone up. Although past performance doesn’t guarantee future returns, investing in broad market indexes has been a successful strategy for many.
Deciphering the Numbers
When you’re considering an index fund, two things should stand out: the long-term returns and the cost. Let’s break these down.
- Long-term Returns: This indicates how the index (and by extension, the index fund) has performed over time. For instance, the S&P 500 has had average returns of around 10% annually over lengthy periods, though there are yearly fluctuations. Checking past performances can give you a hint of potential future returns, but always remember, past performance doesn’t dictate future outcomes.
- Cost: Every index fund has an associated cost called the “expense ratio.” It’s a yearly fee, given as a percentage of your investment. For instance, an expense ratio of 0.06% means you’d pay $6 for every $10,000 you invest annually. Lower is always better here. Some funds might also have sales loads or commissions, but many don’t. Always aim for no-load funds to save more.
Getting Started with Index Fund Investing
Beginning with index funds is relatively simple. Here are steps to get you started:
- Determine Your Investment Goal: Are you saving for retirement, buying a home, or building wealth for other reasons? Knowing your goal helps you choose the right index fund mix.
- Choose a Brokerage: Platforms like Fidelity, Charles Schwab, or Vanguard offer a range of index funds. Once you’ve set up an account, you can buy index funds just like you’d buy a single stock.
- Diversify Across Indexes: Don’t put all your money in just one index. Consider a mix of U.S. stocks, international stocks, bonds, and perhaps other asset classes. This strategy can help further reduce your risk.
- Stay Consistent: Investing is a long-term game. Even when the market is down, continue your investment journey. Over time, consistency can lead to significant growth.
- Review and Adjust: As you approach your investment goal, or as your financial situation changes, revisit your index fund allocation. Ensure it still aligns with your goals and risk tolerance.
8 Popular Index ETFs to Diversify Your Portfolio
- VOO (Vanguard S&P 500 ETF): This fund seeks to track the performance of the S&P 500 and comes with a 0.03% expense ratio.
- SCHB (Schwab U.S. Broad Market ETF): This fund competes with the very popular VTI. They both track the U.S. total market (large, mid, and small cap companies) but use different indexes to achieve this. VTI uses CRSP US Total Market Index, and SCHB uses the Dow Jones U.S. Broad Stock Market Index. They both have a 0.03% expense ratio, but SCHB has slightly outperformed VTI over the last 10 years.
- SCHG (Schwab U.S. Large-Cap Growth ETF): You get growth with a low 0.04% expense ratio, tracking the Dow Jones U.S. Total Stock Market Large-Cap Growth index. The fund has outperformed the S&P 500 over the last 10 years, but has underperformed another popular growth fund, QQQ.
- QQQ (Invesco QQQ Trust): One of the most popular large cap growth funds, the QQQ has a fairly high expense ratio of 0.20%. However, its performance over the last 10 years is hard to ignore. This fund tracks the NASDAQ 100 Index.
- IJR (iShares Core S&P Small Cap ETF): This fund tracks the S&P Small Cap 600 index and comes with a 0.06% expense ratio.
- SCHD (Schwab U.S. Dividend Equity ETF): This dividend fund has exploded in popularity due to its relatively low volatility and strong total return performance. It tracks the Dow Jones U.S. Dividend 100 index, and has a 0.06% expense ratio.
- SCHF (Schwab International Equity ETF): The SCHF ETF uses FTSE All-World Developed x US underlying index. This gives you access to the top international businesses in the developed world (excluding the U.S.). It comes with a 0.06% expense ratio.
- VXUS (Vanguard Total International Stock Index Fund ETF Shares): Want exposure to international developed and emerging markets? VXUS has you covered. The underlying index for this fund is the FTSE Global All Cap ex US Index. It has a 0.07% expense ratio.
Index funds offer a straightforward, cost-effective way for beginners to enter the investing world. By understanding the basics and making informed choices, you can set yourself on a path to financial growth and security. Remember, every investor’s journey is unique. Do your research, stay consistent, and always seek knowledge.