How to Invest in Index Funds
Warren Buffett said that if you are not going to learn how to invest at the professional level, you should "just invest in a few good, no load index funds." This article is about the how, what, where, when, and why of index investing.
Why should I invest in index funds instead of stuffing my cash into my mattress?
The benefits of indexing are indisputable—the strategy is cheap, it’s transparent, and it’s no-fuss (once you’ve decided which benchmarks you want to track). And in recent years, indexing has worked particularly well with the world’s most widely mimicked benchmark, Standard & Poor’s 500-stock index.
If you index, you cannot beat the market. This is what you get yourself comfortable with. You will only receive the market return and that's it. In my book, this is perfectly acceptable for a passive investor.
The S&P 500, which was founded in 1927 and has been in it's current form since 1957 has risen from 249 in 1927 to 2,431 as of June 9, 2017 a total return of 976% or 10.8% annualized. Even market returns have been good enough to create enormous wealth over that 90 day period.
Sticking your cash in your mattress would lead to zero return on it, and even worse, inflation would take a large bite out of that wealth each and every year as the purchasing power of that cash decreases. This is the time value of money problem. Money in the future is not worth as much as it is today because of inflation.
Which Index Fund(s) should I choose?
The choice of which index funds you should choose can be impacted by your age and investment time horizon. Money that is in the stock market is five year money. You should not need the money for at least five years. Five years gives the market time to correct (which you cannot predict) and come back. That is why we call it five year money.
Although the five year rule must be followed, your age may be a factor. If you are already retired, and you are living off of your investments, you must still follow the five year rule.
The best advice I can give to someone who wants to invest in index funds as their primary strategy is to pick two or three funds that are based off of major indexes such as the S&P 500 and Dow Jones Industrial Average. These are the most well-known averages and the S&P with 500 stocks is fairly well diversified. The Dow only has 30 stocks but they are big diversified corporations so that would still be all-right.
The key factors in choosing an index funds are:
- Minimum investment - most index funds have a minimum investment that they require to buy in the first time.
- Expense ratio: this is the fee you will pay every year and is based on assets under management (how much you have invested in the fund)
- Sales charge (load) - this is the fee up front for buying into the index fund. The index funds YOU are looking for are "no load" meaning no up front sales charge. This maximizes the amount you have compounding from the start.
Here are some specific index funds to take a look at (I receive no compensation if you click the links):
Index Fund Name
What kind of fees will I be charged?
- The first fee you will be charged when buying an index fund will be the commission your brokerage charges you for buying into the fund. You can buy a lot of index funds directly from the fund management company and avoid the omission.
- The second fee will be the sales charge or "load" if there is one. There can be "front end" or "back end" loads. A front end load is a fee charged as a percentage of your investment at the time that you buy. When you make the purchase, you will end up with slightly less invested than you expect and the difference is the fee that you were charged.
- The third fee will be the "expense ratio" that you will be charged to you throughout the time you hold the fund. You won't see this on your statement, it's deducted from the returns before they get to you.
- Finally, when you sell the fund, you may be charged a back end load or percentage based fee.
- One major, over-looked key to successful index fund investment is to make sure you understand, AND MINIMIZE, any fees charged by the index fund manager. The fewer and lower, the better.
How are mutual funds priced?
Each business day, by law, mutual funds determine the price of their shares.
They do this by taking the current value of all a fund's assets, subtracting the liabilities, and dividing the result by the total number of outstanding shares.
A fund's share price is known as the net asset value (NAV).
If a fund receives your request to buy or sell a fund before the close of regular trading hours on the stock exchange it is listed on, your transaction will receive that day's closing price.
If the fund receives your request after the market closes, your transaction will receive the next business day's closing price.
What is a good buying plan for index investors?
Just like common stocks, in my opinion, you should gradually buy index funds over time. Markets will fluctuate and it is impossible to predict which direction they will go. To avoid any time of "market timing", I suggest setting up a monthly buying program and stick to it religiously. Buy every month, month in and month out, and let the market work its magic over a long period of time.
I would also select only a few index funds. No need for a bunch of them. They are already diversified. Stick with two or three of the lowest expense, no load ones you can find.
How should I calculate my returns?
My recommendation is to only calculate your returns once per year, after the first three years. Don't expect a ton to happen the first two years.
To calculate the returns, the math is simple. When you receive your December statement, grab it and the December statement from the previous year and find the "account net worth" number which represents the total value of your account at the end of the year. Subtract the most recent year's net worth from the previous years net worth. The difference is your gain (or if negative, your loss). To convert the gain or loss to a percentage, divide it by the prior year's account net worth.
Do that for each of your investment accounts and you can start tracking how the index funds are performing.
Just like any other investment, not every index fund is the same, and you will need to master the process and decision making framework for selecting which index funds you invest in. The mantra is "minimize expenses." Pick three or so funds with the lowest fees and expenses and you should get close to market returns over your holding period.