Warren Buffett famously said “investment must be rational; if you can’t understand it, don’t do it”. When you’re getting started in investing, this advice can be tricky. Personally I felt like I didn’t understand anything when I decided to get started, so… do I invest in nothing? Happily, there’s a solution to simplifying how you choose what to invest in.
That solution is index funds. These funds track the performance of a broad market index, such as the S&P 500 or Dow Jones Industrial Average. They’re easy to understand and manage, so you won’t have to worry about picking individual companies and trying to understand each and everyone of them.
In the following article you’ll learn what an index fund is, how to get started investing in index funds, and finally, how to buy index funds.
Investment must be rational; if you can’t understand it, don’t do it
Warren Buffett
First Of All, What’s An Index Fund?
An index fund is a collection of stocks or bonds that tracks the performance of a stock market index, such as the S&P 500 or Dow Jones Industrial Average. These funds are often designed to provide broad exposure to the overall market without requiring active management.
What’s active management you might ask? Active management is when a fund manager actively monitors the market and chooses stocks and bonds to include in a fund. Generally, it’s more expensive to have someone do this work and you’ll see that cost come up in the expense ratio of a fund.
On the other hand, passively managed funds simply mimic a well established index of stocks or bonds instead of going through a hand selection process. This usually adds up to a lower expense ratio, something that will mean greater earnings for you, the investor, in the long run.
Understand The Basics Of Index Funds
There are approximately 5,000 financial indexes in the US alone. These indexes are designed not just as investment vehicles, but also as performance indicators. The S&P 500 and the Dow Jones Industrial average are often used as measures of how healthy the overall market is.
Brokerage houses, such as Blackrock, Fidelity, and Vanguard, then build funds that align to the composition of these indexes. When investors purchase the fund, they are buying into all of (or most of) the companies within that index, and naturally diversifying their portfolio.
If you want to know what stocks a fund is composed of, there are plenty of places across the web that will list a fund’s holdings. Below is a screenshot of the top 10 holdings for SPY, an index fund that follows the S&P 500.
Start Investing Today
Your biggest asset as an investor is time. The longer you invest at regular intervals for (dollar cost averaging) the more the natural volatility of the market will even out, historically that means a nice solid graph line that points up and to the right.
For example, this is the graph of the entire stock market in 2022. Looks pretty terrible right?
On the other hand, if I look at the entire stock market over the course of the last 20 years, things look a lot smoother. In fact, an investor who bought a total stock market fund in 2001 will have more than doubled their earning by now.
This is why the best time to start investing was yesterday, and the next best time is today. The longer you give your money to grow, the more likely it is to grow. Even in a market downturn, like right now.
How To Buy An Index Fund
Ok, so by now you might be thinking, alrighty I gotta get me some of these index funds… but how? The mechanics of how to buy an index fund are pretty simple after you do it the first time. Honestly, I have bought funds while sitting on a train or out to dinner.
Set Up An Account With The Brokerage Of Your Choice
There are plenty of brokerages out there in the world, Vanguard and Fidelity are two popular choices, personally I have Charles Schwab, but that’s because my former employer used them. You can check out Nerdwallet’s ratings here.
I have found these companies to have great customer service. If you need help with your set up or deciding what type of account is best for you, shoot them a call. Make sure to set up a way to make regular deposits. I like mine to be automated, but you do you.
Remember, once you’re nailed this step, this account is merely a container for your money, you’re not investing until you’ve purchased assets.
Choose A Fund That Suits You
You can find whole sections of bookstores made up of books that try to answer this question. Personally, I am a long term investor, which means I purchase broad market index funds with low expense ratios. What you choose will have everything to do with your own personal situation.
Keep in mind that there are two main types of index funds: passive and actively managed. Passive index funds simply follow the performance of a certain type of fund, while active index funds hand pick individual companies.
There is a term in investing called “alpha”. It’s what everyone wants and few achieve. Alpha means to beat the market in returns. The average stock market return over the last 30 years is 9.89%. Essentially, to reach alpha, you’d need to have a return on your investments of greater than 10% in the long run. According to Investopedia, fewer than 10% of funds achieve alpha.
This is why I choose low expense ratio, passively managed index funds. Historically, its uncommon to beat the market and I don’t want to pay extra for a long shot.
Decide How Much Money You Want To Invest
You do not need to save money to invest. But you also don’t want to throw a dollar in an account and wait around to become a millionaire. You’ll need to know how much money you have each week, month, or year to put into your account.
The best way to do this is to work through your budget. Inspired by my brilliant partner, I’ve come to love a good framework, and I think the best one out there is the 50/30/20 budget. This budget allocated 50% of your monthly spend to needs, 30% to wants, and 20% to savings. You can put at least some of those savings into your investment account.
You might also be learning about investing because you want to understand your retirement account at work. Most companies will have some sort of management for you, but with a little knowledge you can understand what they’re doing and make informed choices for yourself. The most important thing though -max out your yearly contributions! Do not pass up free money!
A Note on ESG Funds
One way to put your money where your values are is to invest in ESG funds. ESG stands for environmental, social, and governance and funds that are considered ESG include these factors in their fund strategy.
If you want to include this strategy for your portfolio, note that there are MANY options and strategies. The two most common investment strategies are inclusionary and exclusionary.
Inclusionary funds only include companies that meet certain ESG criteria. For example, I have shares of WOMN, an inclusionary fund that only holds shares of companies with a focus on women’s empowerment.
Exclusionary funds exclude bad actors, but keep everyone else around. Some of the most commonly excluded companies are fossil fuels, guns, and companies with human rights violations. Vanguard offers a variety of exclusionary funds.
ESG hasn’t been around that long, so many of these funds don’t have a long track record. That unknown adds a little more risk to ESG investing. Do your research and make the right call for you and your particular situation.
Before You Invest, Keep In Mind…
There is no such thing as investing without assuming some risk. Here are a few things to ask yourself to help make sure that you invest according to your own risk tolerance and goals:
- What is the expense ratio? How much might this fund cost me?
- How has this fund performed over the last 5+ years? Is it more volatile than the market as a whole?
- What are the funds holdings? Do they work with my diversification strategy?
- What does the fund’s prospectus say? Does that strategy work for my goals?
In Closing…
Index funds are common choices for beginners, and long-term investors. They make understanding your investment choices simpler, cheaper, and oftentimes, less risky. Following Warren Buffett’s advice, tends to be prudent, so whatever you do, remember to only invest in what you understand!
