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How to Invest in an Index Fund or ETF

A few weeks ago I posted an article explaining what index funds and ETFs are. If you don’t know what they are, then check out What’s an Index Fund and What’s an ETF? before reading on.

Stock Market Chart

Refresher: What are Index Funds and ETFs?

So what’s an index fund and what’s an ETF? As a refresher:

What is an index fund? A fund is simply a group of smaller investments you buy in a single package. An index is just a measure of a financial market. So an index fund is a fund that mirrors a certain index. For example, the S&P 500 Index measures the stock performance of the 500 biggest companies in the U.S. You can buy an S&P 500 index fund from firms like Vanguard, Fidelity, or Charles Schwab that tracks the S&P 500 – giving you exposure to the stock performance of the 500 biggest companies in the U.S.
What is an ETF? An ETF, or exchange traded fund, is a fund that trades on a stock exchange – just like the stock of Google or AT&T. As a consequence of being on an exchange, ETF’s offer more liquidity than index funds (you can buy and sell ETFs during the day; you can only buy and sell index funds at the end of the day), which is perhaps the biggest difference between index funds and ETFs.

ETFs also offer lower minimum purchase requirements (you can buy as little as one share of an ETF; index funds sometimes have minimum purchase requirements of $3,000-$50,000 or more) and sometimes have lower expense ratios. There is also a more diverse universe of ETFs that you can choose from.

What are the Benefits of Investing in Index Funds and ETFs?

Index funds and ETFs offer 3 main benefits over investing in traditional mutual funds or selecting individual stocks and bonds:

1. Simplicity

There are about 100,000 publicly traded companies in the world. In the United States, just under 4,000 companies are actively traded on the NYSE or Nasdaq, with another 15,000 traded over-the-counter (not on a major stock exchange).

This makes the process of narrowing the list to just a handful of worthy investments very difficult – and why it’s so hard for most investors to beat the overall market return. In fact, on average 70% of mutual fund managers fail to beat their benchmarks in any given year (the results of transaction costs and fees).

But if you’re investing in an index fund or ETF, you really can just sit back, kick your feet up, and relax.

With an index fund, you’re making a simplified bet on the total stock market. Sure, the stock market has it’s ups and downs from year to year, but over the long-run it’s averaged ~9.5% per year. Plus you really don’t have to do any work. That’s pretty damn good.

Here’s how J.D. Roth from Get Rich Slowly puts it:

Do index funds always come out ahead in a given year? Not at all. In fact, they’re usually in the middle of the pack. By definition, index funds produce an average market return — no more, and no less.

However, over the long term — ten years, or twenty, or thirty — a remarkable thing happens. Index funds float to the top. It turns out that average performance in the short term is actually above average in the long term.

Index funds are meant to be steady and boring. But that’s the difference between getting wealthy slowly and getting poor very quickly.

2. Diversification

In one of my recent posts (What Warren Buffett Has to Say About Seizing Big Opportunities), I talked about how Warren Buffett thinks that an enterprising investor who wants to achieve an above-market return should only focus on a few great investments.

But for a defensive investor who doesn’t have much experience investing and wants to match the total stock market return, Buffett totally recommends index funds.

In fact, Buffett has said that investing in index funds is the best investment strategy for “small investors who don’t have time to research individual companies“:

The best [strategy] in my view is to just buy a low-cost index fund and keep buying it regularly over time, because you’ll be buying into a wonderful industry, which in effect is all of American industry. If you buy it over time, you won’t buy at the bottom, but you won’t buy it all at the top either… People ought to sit back and relax and keep accumulating over time.

It’s the saying “Don’t put all your eggs in one basket” in action.

Unless you have enough time to thoroughly research individual stocks and are incredibly talented, you really shouldn’t be trying to pick the next Google or Apple.

Instead, you should be spreading your risk across multiple assets (stocks, bonds, real estate, cash) and across multiple securities within each asset class (various stocks, various bonds, etc.). Index funds allow you to do this, very easily and very cheaply.

3. Low Fees

Kristen Wong from Two Cents explains the low fee concept very well:

With other funds, an advisor or investor picks and chooses your individual investments. He or she keeps a close eye on them, then buys and sells those individual investments according to their performance. They want to beat that average ~9.5% return by actively managing your fund. We call this active investing, and you pay for the work that goes into this.

When you buy a fund, you pay an expense ratio no matter what, and this is a fee that includes all the expenses the fund incurs. With active investing, this ratio includes a higher management fee for the extra time and effort.

On the other hand, because index funds are designed to simply mirror an index, they don’t require much maintenance at all. Again, if the index does well, your index fund does well. If the index drops, your index fund drops. We call this “set and forget” investing, or passive investing. There’s no maintenance involved, so the fees are much lower.

This study from Morningstar found that, over time, index funds outperform actively managed funds. Index funds are generally always cheaper than actively managed funds, and this can make a big difference in your return over time. Depending on the fund, active funds might very well beat the market, but you’ll pay a price for that. Sometimes it’s worth it, but you know what you’re getting with index funds: low fees.

How to Choose an Index Fund or ETF

Index Funds

So what index fund should you choose?

Vanguard’s index funds are generally viewed as among the best on the market. The Vanguard 500 Index Fund (VFINX) pioneered the index-fund arena and has dutifully mirrored the returns of the S&P 500 for more than 40 years. With the fund’s low expense ratio of 0.17%, you’ll pay just $1.70 per year for every $1,000 you have invested in the fund, compared to $10 or more per $1,000 for many actively managed funds.

The Vanguard Total Stock Market Index Fund (VTSMX), owns those same S&P 500 stocks but adds small and midsized company stocks to the mix. Meanwhile, the Vanguard Total International Stock Fund (VGTSX) owns shares of companies from around the world, ranging from the largest companies in the industrialized regions of Europe and Japan to up-and-coming stocks in emerging-market countries with faster-growing economies.

Here’s a complete list of Vanguard’s index funds. Other companies, like Fidelity, also offer compelling products.

Your only job here is to ensure expense ratios are low (usually 0.25% or lower is attractive versus the 1.00% or more charged by actively managed funds) and that the index fund actually does a good job tracking the underlying benchmark. As always, double check for hidden fees and expenses.

ETFs

The downside with index funds is that most of them have pretty high minimum buy-in limits – often between $3,000 and $10,000.

Rather than investing in an index fund, you can instead invest in an index ETF, which don’t have any limits. Many index funds also offer similar ETFs.

For example, the Vanguard 500 Index Fund is available as a $3,000 fund (VFINX), a $10,000 fund (VFIAX), or an ETF (VOO) which is currently trading at $172.34. As it turns out, the expense ratio for VFINX is 0.17% but the expense ratio for both VFIAX and VOO is 0.05%.

Dollar-Cost Averaging

Unfortunately Ben Graham – the father of value investing – died in 1976, just a year after John C. Bogle and Vanguard launched the first index fund for individual investors. So he never got a chance to recommend index funds. However, Graham was a proponent of dollar-cost averaging.

Dollar-cost averaging (DCA) is the technique of buying a fixed dollar amount of a particular investment on a regular schedule, regardless of the share price.

An investor, for example, could invest 30% of his or her paycheck in an index fund every month. Although there may be swings in the short-term, over the long-term the market will continue to rise. DCA is most effective because, by sticking to a schedule, you can avoid the common mistake of buying into the market at a peak and selling at a low. When the market is low, your fixed dollar amount will buy you more (cheap) stocks; when the market is high, your fixed dollar amount will buy you less (expensive) stocks.

Graham offers this quote from Lucile Tomlinson, who studied and wrote a book on different formula investment plans:

No one has yet discovered any other formula for investing which can be used with so much confidence of ultimate success, regardless of what may happen to security prices, as Dollar Cost Averaging.

Summary

In the end, investing with index funds are ETFs is incredibly easy, yet it’s one of the best ways to build wealth over the long-term. So just sit back, relax, and watch as your portfolio gets bigger and bigger.