Intro to Low Cost Index Fund Investing
Have you heard of low cost index fund investing? Investing your money in the stock market doesn’t have to be difficult or stressful and you certainly don’t have to spend dozens of hours researching to succeed for the long-term.
In fact, I would argue that the most effective long-term wealth building strategy for the stock market also happens to be the simplest. Our investing advice is this:
Buy an ultra-low-cost diversified index fund and continue to purchases new shares automatically on a set time schedule. We suggest the Total US Stock Market Index Fund (VTSAX) or S&P 500 Index Fund from Vanguard, but there are comparable funds at Fidelity and Schwab that accomplish the same goals.
Don’t check how the market is doing, don’t get skittish and sell when the market drops, just keep pumping money in there week after week (Vanguard lets you setup an automatic investment on a weekly, bi-weekly or monthly basis, so whatever best fits your schedule).
You’re going to wake up one day as an extraordinarily rich person and you’ll have experienced much less stress along the way than nearly every other investor!
How Does Warren Feel about Low Cost Index Fund Investing
Don’t believe us? Here is Warren Buffett – the greatest investor the world has ever known – from his 2013 Berkshire Hathaway Shareholder Letter:
“The goal of the non-professional should not be to pick winners – neither he nor his “helpers” can do that – but should rather be to own a cross-section of businesses that in aggregate are bound to do well. A low-cost S&P 500 index fund will achieve this goal.”
“My money, I should add, is where my mouth is: What I advise here is essentially identical to certain instructions I’ve laid out in my will…My advice to the trustee could not be more simple: Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund. (I suggest Vanguard’s.) I believe the trust’s long-term results from this policy will be superior to those attained by most investors who employ high-fee managers.”
If that advice is good enough for Warren Buffett’s wife and children and their billions of dollars, you can bet it’s solid for your family too!
Our favorite resource to learn more about low cost index fund investing is the Stock Series at JLCollinsNH.com. This has become THE resource for the financial independence community and it is essential reading.
What is an index fund?
Investopedia defines an index fund as, “An index fund is a type of mutual fund with a portfolio constructed to match or track the components of a market index, such as the Standard & Poor’s 500 Index (S&P 500). An index mutual fund is said to provide broad market exposure, low operating expenses and low portfolio turnover.”
In the case of the S&P 500, you’re buying a tiny piece of all 500 companies in the S&P 500 index. So many people miss this fundamental point: You are not buying a piece of paper when you buy a stock or mutual fund, you are buying an ownership percentage of an actual company!
So instead of short-term trading and getting lucky on stock price fluctuations, we are going for long-term wealth building by buying a piece of either the 500 biggest publicly traded companies in the US (S&P 500 Index) or essentially every publicly traded company in the US when you buy a Total Stock Market Index Fund (at publication of this article, the Vanguard Total Stock Market Index Fund has nearly 3,600 companies in the index).
The Impact of Fees on Your Investment
Over the long-term, nearly no investor can outperform the market (and don’t get us started on timing the market, which is even harder). If you take that as a given, then the fees are the single most important factor to building your wealth.
Here’s a visual representation of the impact of fees on your investment:
Scenario 1 : Low Cost Index Fund all the way
We’re assuming someone starts with $100,000 and plans to invest for 40 years while adding $0 future dollars. We’re assuming an 8% gross annual stock market return, however if you invest in VTSAX the expense ratio is 0.05 percent annually, so it reduces your annual return to 7.95%. When compounded over 40 years (thanks to this investment calculator for the math), you end up with an astounding $2,132,582.
Scenario 2 : Mutual Fund instead of an Index Fund
However, let’s say instead of VTSAX you decided to invest in a mutual fund with a 1% expense ratio, so your net annual return is now 7%. That 1% fee didn’t sound like much upfront, but instead of over $2.1 million in VTSAX, you now have only $1,497,445. You’ve lost nearly a third of your investment just by investing in an actively managed (high fee) mutual fund!
Go with the low cost index fund
Scenario 3 : Financial Advisor + Mutual Fund instead of an Index Fund
Now, just for fun let’s say you doubled down and hired a “helper” (thanks Mr. Buffett for that great term!) also known as a financial advisor and they charged you 1% plus invested you in a mutual fund with a 1% fee. So your net return is now only 6%. At the end of 40 years you only have $1,028,571. You now lost half your potential return for absolutely nothing! I can almost guarantee that helper’s “brilliance” wouldn’t have brought you any increased returns over the long-term and the drag of their expensive fees just kills your return.
Go with the index fund
Personal Capital this is our preferred tool for tracking our investments and its free to set up
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