Investing 101: Index Funds
Financial freedom – Planning to retire before 40 and spend your days traveling the world living off your nest egg is what most of us are working for. You want to earn enough money so you can stop working early enough to enjoy your time on this planet!
But how do you get there?
The Secret to Wealth
The more you think about this dream, the more reality sets in when you realize you haven’t even started saving yet. Does this mean you have no chance of reaching financial freedom?
It is never too late to get started, but there is one step that you have to take in order to get there – you have to invest.
But investing is complicated and risky!
I hear you. Everyone feels this way in the beginning, but I promise you it gets easier. To gain a solid amount of wealth, investing is crucial. You do have the option of counting on a savings account or stashing your money in a mattress. However, you will be missing out on one of the most powerful tools you have in your toolbox: Compound Interest.“Compound interest is the eighth wonder of the world. He who understands it, earns it… he who doesn’t…pays it.” -Albert EinsteinClick To Tweet
I will dig deeper into this in future articles. To put it simply, compound interest makes your money work for you instead of you working for it. When your money is invested, it is growing. When your nest egg is in a savings account, it is often losing value due to inflation.
So how do you get started with investing in the first place?
Index Funds vs. Individual Stocks
The first thing that comes to mind for most people when you talk about investing is the stock market. Turn on one of the many finance TV shows and you will be overrun with stock picks.
“Now is the time to buy! Sell now!”
There is talk on individual companies, Initial Public Offerings, and how a company’s stock is being affected by a media disaster. If you watch long enough, you will notice that one of the most successful and simple ways to win while investing is often overlooked: Index Funds.
Index funds take the complexity out of investing. Instead of focusing on deciding which individual stock to invest in, an index fund has a simple solution – own all of them.
These funds are similar to mutual funds in that they own a large amount of stock in different companies (often hundreds) within a market. Because of this, index funds mimic the market’s annual returns. For example, an S&P index fund’s return will be nearly identical to the S&P 500’s returns. This translates into a much safer investment, but also a much more profitable one in most cases!
Don’t Follow the Crowd
The next time you are on the golf course or by the water cooler at work and stocks come up in conversation, listen closely. You are sure to hear someone bring up the time they made a great trade and made thousands of dollars, or how they heard of a great stock pick and won big.
These stories excite you and get your gears turning as to how you can do the same thing. After all, if you can invest in just one startup business in Silicon Valley, you can ride the money train all the way to retirement if it wins big!
That sounds an awful lot like gambling doesn’t it?
The topic you won’t often hear about when talking to your peers is the less sexy investment of index funds. You will not see the drastic spikes in index funds that you do with individual stocks. You also won’t see the dramatic drops that send investors into a panic.
Now, I am not saying that the stock market as a whole will not drop in value. It can, but when you look at the stock market’s history, it always goes up. There will be corrections and crashes, but on average it always bounces back. Every correction is followed by a profit for those who stuck it out. Individual stocks leave the fate of your money in one company. If that company goes bankrupt, your dream of sipping drinks on the beach can quickly fade away.
The Lazy Portfolio
Investing in index funds is often touted as the “lazy portfolio”. The reason for this is due to the hands off approach of the investment. Index funds are passively managed. What this means is that there is not a fund manager making constant trades on a daily basis. Actively managed funds like mutual funds often have fund managers making daily trades to buy and sell shares. This method helps them get the highest returns they can. The problem with this is that most of them do not outperform the market.
What does this mean? It means that in a way, you can simply invest and not worry about it. Now, I do suggest that you monitor your investments, but with the Lazy Portfolio, just keep an eye on the markets and over time you will make money.
If you spend your time buying and selling individual stocks on a daily basis, several things will happen:
- You will pay higher taxes. By selling your stock holdings within a year of the buy, you will pay a higher tax than if you simply buy and hold.
- You will pay a fortune in commission. Each trade requires a commission fee that can really take away from any gains you do make.
- You most likely will not outperform the market. Unless you are a full time investor that studies in depth before every trade, the market as a whole will usually earn a far better return. Even those that manage billion dollar funds for a living have a difficult time beating the market.
“Robo Advisors” use algorithms to actively manage your investments reallocating and selecting funds that are the most beneficial for your financial goals. This software is designed to take over the hassle of managing your funds by handling it for you.
Overwhelmingly, these Robo Advisors are investing their client’s money using the Lazy Portfolio method and purchasing passive index funds that mimic the returns of the market.
Investing in index funds will make the average investor’s life much simpler and offer greater returns than putting your time and money into selecting individual stocks.
The 3 Fund Portfolio
Now that you have a solid understanding of basic investing, I am going to quickly cover an important topic: Asset allocation. I will cover this in depth in future posts, but here is some basic information to get you started.
Simplicity in investing is key. This is why the 3 fund portfolio is my personal favorite and the method I use in my own self-managed portfolio. To put it simply, instead of owning 5, 10 or 20 funds, your portfolio is narrowed down to three simple index funds.
- Stock market index fund
- International-stock index fund
- Bond index fund
By having your investments split into these three fund types, you create an asset allocation that is extremely well balanced.
The Stock Market Index covers your assets in the S&P 500, so you get to benefit from the success of America’s greatest companies such as Apple and Google. The International Stock Index funds give you the ability to take part in the success of emerging markets. Lastly, the Bond Index fund is your conservative asset, saving you from major losses in most market crashes.
It is Your Turn to Win With Money
Financial independence is more possible today than it has ever been. By reading and using resources such as this, you can win with money. The most important factor that will make a difference in securing your financial future is actually investing.
Get some skin in the game!
If you pass on investing, your money will never work for you, so get started today by putting what you just learned into action and go make some money!
What are your thoughts on investing? How do you invest?
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