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A Guide to Index Investing

Zina Kumok writes about financial planning for Wealthsimple. She has eight years investing experience and five years experience as a personal finance writer. Her work has been featured in Investopedia, DailyWorth, MoneyUnder30 and DollarSprout. Zina runs a personal finance blog called ConsciousCoins.com and she has been a two-time finalist for ‘Best Personal Finance Contributor’ at the Plutus Awards. She has a Bachelor's degree in Journalism from Indiana University.

Millennials and many other adults find investing in the stock market scary. They think the stock market is too volatile and confusing. They see massive downturns in the market as proof that there’s no good place to invest your money.

Unfortunately, that type of fear is keeping people from building real wealth. It prevents them from having a nest egg that allows them to retire when they want, instead of working for more of their golden years.

That’s where index investing comes in. It’s a relatively simple way to invest that’s also easy to get started in. It doesn’t require a financial background or special degree to understand.

Curious about index investing? Ready to get over your fears? Keep reading to understand how index investing might be the key to your financial future.

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What Is Index Investing?

With index investing, you’re investing in a fund that tracks an index. These various indices—which include the S&P 500, Nasdaq 100, and the Russell 2000—are comprised of hundreds or thousands of companies. When you invest in an index fund, you’re buying tiny shares of hundreds of different companies. This makes index fund investing more diverse than buying shares of an individual stock or bond.

Index investing is popular because it allows regular people who don’t have a lot of money to diversify their portfolio easily. If you can only afford to invest $100 a month, you can still get a proper amount of diversification if you choose index funds.

Index funds may follow funds that are 100% invested in stocks or 100% in bonds. This depends on the type of index fund you choose.

Maria Nedeva, PhD and creator of The Money Principle compares index funds to meeting your life partner.

“They love you back and treat you well, they return faithfully when you commit, and they will look after you when you need it most."

Maria cautions that when investing in index funds there is the probability of a “black swan”; an unpredictable catastrophic event that could cause an unfavourable return but adds that there’s "nothing you or anyone else can do about it."

Benefits of Index Investing

One major benefit of index funds is that they’re passively managed. This means there’s not a fund manager deciding which companies to start and stop holding.

Passively managed funds have lower fees than actively managed funds, which means investors can keep more of their returns for themselves. The difference can be staggering. For example, a large-cap active fund can have a fee of 1%, but an S&P 500 index fund has an average expense ratio of .15%.

This difference may seem small, especially if you believe that active funds will yield higher returns. But if you consider that you might only earn 7% a year, then paying 1% in fees is actually a huge part of your total earnings. Some calculations find that paying 1% in fees is equal to losing $500,000 total after 40 years.

But what makes passive index funds stand out is that they also have higher returns than actively managed funds. Some active fund managers think they can beat index funds, but they’ve never been able to do it for a significant period of time.

Famous investor Warren Buffett is a huge fan of index funds and recommends them for most people. In 2008, he bet an active manager that he would make more money investing with an S&P 500 index fund than the active manager would do picking his own funds.

The bet ran on for 10 years, with Buffett proving the decisive winner. His pick averaged 7.1% while the competition’s selection only earned 2.2%.

Limitations of Index Investing

Index investing isn’t perfect. When you invest in an index, you’re missing out on key industries and countries. For example, an S&P 500 index fund may not hold companies in developing countries. These often have higher returns because there’s so much room to grow.

Another major problem with index funds is that you can’t pick and choose which companies are in the index fund you invest in. This can be a problem if you have concerns about the moral or ethical decisions that these companies make.

Unfortunately, you can’t cherry pick specific companies out of an index fund. If you invest in an index fund, you’re investing in all of those companies. Many people are surprised to learn that companies they don’t support in other ways are part of their investments.

For example, Wells Fargo was fined $575 million in 2018 for opening fake accounts and charging unnecessary fees to customers. But if you invest in that VOO fund, Wells Fargo is one of the top 30 companies in that index fund.

There are index funds out there dedicated to companies who promote environmental and ethical beliefs. You have to be judicious in researching these index funds and deciding if they make sense for your portfolio.

How to Start Index Investing

Interested in index investing? Getting started is easy.

Pick an Investment Strategy

First, decide if you want to pick index funds yourself or have a robo advisor do the work for you. Many robo advisors invest in index funds, some almost exclusively.

You can also choose your own basket of index funds. A good mix of index funds to have is a selection of large index funds along with bonds and small-cap index funds. An S&P 500 index fund is a good option for many people, especially younger investors who are just starting out.

You can also hire a financial planner to make these decisions for you. Tell them you want to invest in index funds so they understand what recommendations to make. Depending on your age, current portfolio, and retirement goals, they may recommend investing most of your money in index funds.

A robo advisor decides your asset allocation and changes it as you get older or if you change your goals. This is the same kind of service a more traditional financial advisor can provide.

Decide How Much to Invest

Whether you’re new to investing in general or have been picking stocks for years, you have to decide how much to invest in index funds.

If you’re already investing, you have to decide if you want to move all of your money to index funds. This may be a good idea if you’re currently investing in individual stocks.

If you’re a new investor, look at your budget and see how much you can afford to squirrel away. If you’re traditionally employed, see if your company offers an employer-sponsored retirement account.

They may offer a match on your contributions. For example, many companies will contribute 50% of your contributions, up to 6% of your salary. This means you’ll receive a free 3% match, just for saving money in an employer-sponsored retirement account.

If your company has a matching program, try to save as much as possible to get the match. It’s free money, and there’s no good reason not to participate in this program if you’re ready to invest.

A good rule of thumb is to save and invest between 10-15% of your annual income for retirement. This is a good general goal for everyone to reach, but if you’re 40 and haven’t saved anything, then you probably need to play catch up.

Still, investing 5% of your income is better than nothing. If possible, see if you can make some changes to your budget and try to prioritize investing.

Find Index Funds

If you do decide to invest in your company’s 401(k), you’ll then get a list of which funds they offer. Employers offer a limited selection of funds, but it should be possible to find index funds on that list. You may have to research the funds one by one to see which are index funds and which are active mutual funds.

If you don’t have access to a 401(k) or you’re self-employed, then investing in index funds may be easier for you. First, you have to pick a brokerage account to start your Individual Retirement Account or IRA.

Then, you’ll pick your index funds. Many brokerage companies have their own proprietary index funds. For example, Charles Schwab has its own S&P 500 index fund, which is different than the Vanguard S&P 500 index fund.

Even though index funds are usually comprised of hundreds of companies, it’s still important to be diversified within your index funds. For example, if you pick an S&P 500 index fund, then you should balance that with a bond fund.

If you pick another stock index fund, you may be holding too much in the same companies. For example, the Vanguard Total Stock Market Index Fund has similar holdings as the Vanguard S&P 500 index fund. In fact, many of the same top holdings are identical.

This is where investing in index funds can be confusing for new investors. Index funds are a great way to invest, and they’re better than nothing, but you still need a smart strategy. It’s easy to use index funds incorrectly, such as holding too much in a stock-based index fund when you’re close to retirement.

Another thing to keep in mind when investing in index funds is that you shouldn’t touch your funds when there’s a major downswing in the market. For example, if there’s a recession, some people may get scared when their index fund starts losing value. As history has taught us, the best thing to do is to keep your index funds right where they are. The market always bounces back, but it can’t do that if you’ve withdraw your money.

Last Updated December 2, 2019

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