To grow your wealth, investors have multiple options of researching for individual stocks, asking a money manager to manage your fund via a mutual funds or track the market by investing in an index fund. For the average person who does not want to do his own research to seek out the suitable mutual fund as shown in 5 Best Mutual Funds to Own, a balanced portfolio of index funds is one of the smartest and easiest ways to invest. I consider index fund investing as a smart long term investment strategy that I would recommend to a wide range of people
This article is going to provide a simplified overview on why and how to invest in index funds
Index Funds Definition
An index fund is a collective investment scheme that aims to replicate the movement of an index of a specified financial market such as S&P 500. A method where an index fund replicates the movement of S&P 500 is to hold all securities in the index and same proportion as the index.
The idea of tracking the market via a fund originated from John Bogle who wrote Little Book of Common Sense Investing. If you can't beat the market, be the market. That's the logic behind index funds.
There are several types of index funds. There are index funds which follow the indices such as S&P 500, Dow Jones Industrial Average, funds that follow bond indexes, funds that track international markets, sector index funds (such as Technology, Healthcare etc.)
Pros and Cons of Index Funds
- They have low annual expenses and are tax efficient
- For some index funds, investors can buy them without paying a sales commission
- Know what you are investing in. When you buy an index fund, you pretty know what you are getting. The holdings in an index fund is clearly defined by the rules of the benchmark and are transparent to the investor
- Index funds are simple and keep investor from chasing recent performance or stock market fads
- Unable to outperform the market return
Index Funds List
Some index funds to consider investing in are: Vanguard 500 Index Fund Admiral Shares, Vanguard Total Stock Market Index Fund Investor Shares, Vanguard Total Bond Market Index Fund Admiral Shares, Vanguard Total International Stock Index Fund Investor Shares and Fidelity Select IT Services Portfolio.
Index Fund Investing Strategy
“Most investors, both institutional and individual, will find that the best way to own common stocks is through an index fund that charges minimal fees,” Buffett is quoted as saying on the front cover of Bogle’s book, Little Book of Common Sense Investing. Buffett and Munger’s long career is proof that it is possible to beat the market if you have the correct temperament and the willingness to read constantly and carefully consider risk management. Yet most people aren’t equipped with the emotional temperament, time or talent to consistently beat the market. That’s why both Buffett and Munger have consistently urged most investors to buy low-cost, tax-efficient index funds that mirror the entire stock market. As Buffett says, that’s a way for the “dumb” money to get smart by not paying “helpers” in the financial industry high fees for market-losing and tax-inefficient results.
The rationale why so many famed value investors recommend index fund investing is because an index simply tracks a market so it costs a miniscule amount of money to run an index. So if a fund matches the market's gross return and does so at a cost much lower than the average fund, it will always beat the average fund over time.
John Bogle recommends a simple portfolio strategy to many investors. The simple strategy consists of a 3 Fund portfolio approach where investment allocates investments among a U.S. Total stock market index fund, a Total International stock market index fund, and a U.S Total bond market index fund as shown below.
It is recommended to start invest early and often. For a young investor, it is recommended to start out heavily invested in equities, hold some bond index funds as well as stock index funds. By the time you get closer to retirement or into your retirement, you should have a significant position in bond index funds as well as stock index funds due to the shorter time frame considered. Below shows the difference in wealth between Leandra who invest early as compared to Kevin who only start investing at age 40.
To sum up, index investing is one of the most viable wealth building strategies and it requires the least of time and most suitable for wide range of people.