Invest in Index Funds:
An all too common misconception about buying stocks – it’s like gambling. Normally, the Not Your Ordinary Plan (NYOP) crew would agree with you, but only if you were talking about buying individual stocks. In this post, we will explore the deceptively simple logic behind why you should invest in index funds, and why they are superior to individual stock picking for the average investor.
In fact, index fund investing is a key step in our own plan for reaching financial independence (FI) and retiring early!
What is Index Investing?
First off, what is index fund investing? Just like a company stock, index funds represent ownership of a company. They fluctuate in price on a daily basis, and you can buy them through popular investment management companies (also called brokers) like Vanguard, Fidelity, Charles Schwab, etc. When you own an index fund, however, you own a small piece of many different companies. What these companies are depends on the index fund.
Indexes (technically it’s indices, but nobody says that) are as unique as the companies that make up the stock market. In fact, there are more indexes than publicly traded stocks! A few more popular examples you may have heard of include the S&P 500, the NASDAQ Composite, or the Dow Jones Industrial Average (DJIA).
Note here – it is common to abbreviate indexes, just like stocks, with a 3, 4, or 5 letter “ticker”. For example, Vanguard’s index fund representing the S&P 500 index is called the VFIAX. These tickers make searching, buying, and comparing indexes easier.
Why Invest in Index funds over Individual Stocks?
Back on topic: Why should you buy one of these fancy indexes if you can just pick the next Apple, Google, Tesla, or Amazon stock on your own? Like I said in the beginning, you might as well make a trip to the casino. Less than 70% of new companies survive the two years following their inception. This makes choosing successful single stocks a rare and risky event over your long-term investing career.
Indexes, on the other hand, help investors avoid putting all their eggs into one basket. Owning a broad and diverse portfolio is the easiest way to avoid unnecessary market risk. You will naturally own winners and losers, but long-term investing guarantees the cream will rise to the top – the cream being largely profitable companies you inadvertently own shares of.
An index like the S&P 500 lets you purchase a piece of the top US companies. It is an index that tracks the leading 500 corporations and their stock performance. It’s easy to imagine that the companies in this index are constantly changing. Top performers will stick around longer, while the duds drop out and get replaced. Because of this, the S&P 500 (and similar indexes) are “self-cleansing”.
This self-cleansing phenomenon also means you spend less time doing market research. Instead of sifting through mind-numbing spreadsheets of individual stocks, comparing prices, and guessing what’s undervalued, you can let the index figure itself out.
This sounds too easy…
By now, the more ‘active’ investors reading this piece should be chiming in about how boring this strategy is. They are totally correct, though. Investing in index funds is not sexy. It is not mentally stimulating (once you establish an investing routine). It is not as difficult as picking individual stocks, either. If you are here for an investing challenge, you’ve come to the wrong place.
Okay, have all the haters left?… Good! Then the rest of you are hopefully asking, “How do I get started buying these index funds?” Chances are you already do through your employer. If you have an employee sponsored retirement fund like a 401(k) or 403(b), then there is also a good chance it’s invested in a target retirement fund. A target retirement fund is just another type of index fund, and NYOP believes they are great for beginner investors. For example, if you buy a share of Vanguard’s 2055 target retirement fund (see ticker VFFVX), then you are buying stocks of many individual companies, and some bonds.
Personally, we think target retirement funds are a bit too conservative at our current investing stage, and opt for more aggressive funds like the Vanguard total stock market index or the S&P 500 index (see tickers VTSAX and VFIAX, respectively). But – we are not financial advisors, and this post is not meant to give specific financial advice. All we can say is that we are still young and do not see a need for a large percentage of bonds in our own portfolio yet.
Quick side note – we have been giving specific investing examples from Vanguard’s investing options, but you can find index funds that are equivalent and track the same indexes. Some examples of these companies include Fidelity, Charles Schwab, T. Rowe Price… etc. See the infographic below for a comparison.
What About Index Fund Fees?
Back to the meat of our discussion – that’s right, we still have reasons for why you should invest in index funds! If you have ever invested in an ‘actively managed fund’ or had ‘assets under management,’ then you are no stranger to fees. These fees are commonly between 1 and 2%. That may seem low, but remember average annual stock market returns sit around 7% (adjusting for inflation, and assuming you reinvest dividends). You could be losing almost 30% of your annual growth to fees!
You can escape many of these fees when you invest in index funds. Many index funds have expense ratios below 0.1%. If you didn’t know, expense ratios are the built-in fees associated with owning a fund, and they are expressed as a percentage. Fees and taxes are the quickest way toward a guaranteed loss while investing, so minimize them where you can!
For the image example below, we list the same index funds with their given expense ratios between varying brokerage companies.
Create Consistency When Investing
The last reason why you should invest in index funds is less apparent than the other logic we presented, that is, until you make a habit out of it. Index investing can help remove the emotion we feel while buying or selling stocks. This is especially true if you do it consistently. We already mentioned that buying an index fund will ensure you own both winners and losers. Once you get used to that fact, you won’t feel bad that one of the 500 companies you own goes bankrupt – it will happen frequently!
If instead you try your hand at individual stock picking, the potential downside is equal to whatever you invest. Betting it all on ‘the next big startup’ company will leave an everlasting bitterness in an emotional investor if the stock price plummets. And deep down, we are all emotional investors. Remove the emotion from the equation with consistent index investing.
Is Index Fund Investing Really For Me?
For us, investing in index funds is a pivotal step we take when working towards financial independence. The diversity in our investment portfolio, created consistency to invest, and low fees has convinced us that investing in index funds is one of the best routes to financial success.
Is it your first time hearing the term “financial independence retire early” (FIRE)? Check out our post explaining what financial independence is all about and why we are 100% in ourselves!
If you’re not sure where you are in your financial journey (i.e. should you even be investing?), then check out this article we wrote on how we determine our own order of investing. It will help you maximize every dollar you save, and removes the confusion behind where to put your money. If you need more direction with financial goals, we also have an article to help: set the best financial goals. It will help you decide if you’re doing too much or too little with financial planning.
I’ll leave you with one last quote from John Bogle, founder of Vanguard and creator of the index fund:
“Don’t look for the needle in the haystack. Just buy the haystack!”
Check out our other investing posts!
- Financially Free in 5 Years: How To Achieve Financial Independence
- Barista FIRE: How to Semi-Retire Early and Enjoy Life
- Coast FI in Our 20s: The Best Type of Financial Independence
- How To Invest Your First $1000 (So You Can Retire Early)
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