F.I.R.E. Essentials: Intro To Low Cost Index Fund Investing

Share on facebook
Facebook
Share on google
Google+
Share on twitter
Twitter
Share on linkedin
LinkedIn
Share on pinterest
Pinterest
Index Fund
ChooseFI has partnered with CardRatings for our coverage of credit card products. ChooseFI and CardRatings may receive a commission from card issuers.
Opinions, reviews, analyses & recommendations are the author’s alone, and have not been reviewed, endorsed or approved by any of these entities.  See our disclosures for more info.

ChooseFI Favorite: top rewards card for beginners

Chase Sapphire Preferred Card​

ChooseFI’s top pick for travel rewards! The Chase Sapphire Preferred Card has a 60,000 point sign-up bonus (after spending $4,000 in the first 3 months). The points are ultra-flexible and transfer to 13 airlines and hotels. $95 annual fee.

ChooseFI Favorite: top rewards card for beginners

Chase Sapphire Preferred Card​

ChooseFI’s top pick for travel rewards! The Chase Sapphire Preferred Card has a 60,000 point sign-up bonus (after spending $4,000 in the first 3 months). The points are ultra-flexible and transfer to 13 airlines and hotels. $95 annual fee.

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 love the Total US Stock Market Index Fund (VTSAX) or S&P 500 Index Fund from Vanguard, but there are comparable funds at other discount brokers 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 set up 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!

Related: Vanguard Vs. Fidelity–Which Company Is The Best Choice For You

How Does Warren Feel About Low-Cost Index Fund Investing?

index fund warren buffett

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.

He also wrote a book that illustrates this point, Simple Path To Wealth by JL Collins Full Disclosure: We earn a commission if you click this link and make a purchase, at no additional cost to you. .

Related: How To Prepare For Drawdown During Early Retirement

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.

We are trying to build 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).

What Is Considered A Low-Cost Index Fund?

Index funds are passively managed, which simply means they don't have to pay a bunch of mutual fund managers and analysts to determine which stocks to include in the funds. This leads to less overhead and makes index funds, by their very nature, nearly always “low-cost” in comparison to actively managed mutual funds.

  • The average mutual fund expense ratio will land somewhere between .5% – 1% (with many costing even more).
  • The average index fund expense ratio is under .2%.

But while nearly all index funds will have relatively low expense ratios, certain index funds take things to another level. Most of the discount brokers offer index funds with expense ratios at .05% or below.

And at the end of 2018, Fidelity became the first broker to offer index funds with literally 0% expense ratios.

Related: When 2% Costs Everything: How Investment Fees Cost You Your Freedom

The Impact of Fees On Your Investment

Over the long-term, almost 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 in 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.

Low Cost Index Fund - best case scenario

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 up front, 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 to 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.

Related: Investment Fees are Evil

Can You Lose All Of Your Money in An Index Fund?

While it's technically true that no investment can promise that it won't lose all of your money, the chances of that happening with index funds are about as close to nil as you can get.

Why? Because in order for you to lose all of your money in an index fund every underlying holding (company) would also have to drop to zero.

Over the next 50 years, is there a chance that several companies that are currently in the S&P 500 will tank, end in bankruptcy, and leave their shareholders with nothing?

Well, actually, yes.

And this is exactly why investing in individual stocks can be so dangerous.

But the chances of all 500 stocks in an S&P 500 index fund dropping to zero is highly unlikely (that's actually putting it mildly).

  • And don't forget that Total Stock Market index funds buy little pieces of nearly every publicly traded company in the U.S., often including over 3,500 stocks.
  • The chances of every single publicly traded company in the U.S. going bankrupt at any point in time is nearly a statistical impossibility.

This is the power of diversification. And index funds offer more diversification than any actively managed mutual funds you'll find.

Related: How I Learned to Stop Worrying and Love the Index

How Much Money Do You Need To Invest In An Index Fund?

It really all depends on the brokerage company that you use and the specific index fund that you are looking at.

Many popular index funds have a 0$ minimum investment, while some have $1,000 minimum investments or higher.

Vanguard has an interesting setup in that they offer two versions of their index funds–Investor shares and Admiral shares.

  • The Investor shares have a lower minimum investment but a slightly higher expense ratio.
  • What's really great though is that once your account balance is high enough to qualify for Admiral shares of the fund, Vanguard will automatically graduate you up.

VTSAX, which gets a lot of love around here, is the Admiral share version of Vanguard's Total Stock Market Index fund.

Related: How To Buy VTSAX

What Is The Best Index Fund?

There is no objectively “best” index fund. Since index funds from competing brokers all base their funds off the same indexes, their stock market performances will be nearly identical.

Instead of starting by looking for the best fund, I would first try to decide which broker you want to use for your index fund investing and why. Then once you've decided upon your broker, you can choose which of their index funds to choose by comparing expense ratios and other factors.

To get you started, check out our Vanguard vs. Fidelity guide. Other discount brokers to check out include Charles Schwab, T-Rowe Price, and TD Ameritrade.

Recommended Tools/Resources

Personal Capital Full Disclosure: We earn a commission if you click this link and make a purchase, at no additional cost to you. –this is our preferred tool for tracking our investments and its free to set up.

Related Articles

ChooseFI has partnered with CardRatings for our coverage of credit card products. ChooseFI and CardRatings may receive a commission from card issuers.
Share on facebook
Facebook
Share on google
Google+
Share on twitter
Twitter
Share on linkedin
LinkedIn
Share on pinterest
Pinterest

Comment Disclaimer: Responses are not provided or commissioned by the bank advertiser. Responses have not been reviewed, approved or otherwise endorsed by the bank advertiser. It is not the bank advertiser’s responsibility to ensure all posts and/or questions are answered.

14 thoughts on “F.I.R.E. Essentials: Intro To Low Cost Index Fund Investing”

  1. Jonathan & Brad – Love the show! As you guys have mentioned, even if I can’t implement all the ideas that are presented, grab on to some nuggets and apply them. I’ve done that. My wife and I are currently on our second Chase Sapphire – sitting on approximately 110k Ultimate Reward points. Brad, you opened my eyes to a new way our money can be working for us. The Millionaire Educator has us tax planning for 2017 – with two children and strategic savings, that 10% bracket is certainly within our grasps. Here’s my issue: I want to move our Roths from their current location (where we pay high expense ratios plus an “advisor” fee for each monthly deposit) to Vanguard and go index all the way – most likely 70 VTSAX/ 30 VBTLX. BTW, we’re both in our mid-30’s, so that seems like a moderate blend. But how can I, in good conscience, invest 70% of our Roth assets in VTSAX when that bubble is looking quite plump. Do it anyway and just remember, over the long run, it’ll only be a blip on the radar? Or do we move to Vanguard and play it more conservative because of the current climate? Just wanted a second opinion. Keep up the great work, gentlemen! Jonathan – the site looks awesome!

  2. Hi Jonathan and Brad,
    Your podcast has certainly made it to the top of my list! I’ve already got my friends listening. I have a question about my 401k and pension. I recently left my job due to health issues and I am waiting to see if my application for my company’s long term disability insurance will be approved. In the meantime…what do I do with my 401k and pension? I am fully vested. This is a company I worked for for over 16 years. I know you highly recommend Vanguard and I am thinking of heading in their direction. Do you know what kind of fund I can put this money into or have any suggestions?Do I move some of it or all of it? My HR department told me I could leave it for now as the rate of return is doing pretty well. My performance year to date is 6.09%. I really don’t want to rely on the advice from my HR department! And, I don’t want to pay fees to an investment advisor.
    P.S. I have already opened my Chase Sapphire ultimate rewards card and am on my way to travel freedom! Thanks for all the value you have added with your podcast and website. My husband and I are hooked and spread the word every chance we get!
    Sincerely, Heather

    • Hi Heather, we love that its having an impact and that you are finding it useful. I think you will benefit from episode 19 which will drop in mid april, We interview Jim collins and unpack why we are such big fans of Index funds. If you stick with us you will be an expert on index funds by the end of 2017. If you want to skip ahead, I highly recommend Jim Collins stock series which you can find at jlcollinsnh.com. this answer is very nuanced and would definitely depend on your age but my short answer would be if you are in your 50’s to 60’s you should end with a simple portfolio of VTSAX (Vanguard Total Stock Market Index Fund) and VBTLX (Vanguard Total Bond Market Index Fund) your ratio would depend on whether you were in a wealth accumulation phase or a wealth preservation phase probably 70:30 VTSAX:VBTLX. hope That helps
      Thanks so much for sharing,
      -J

  3. Hi Jonathan and Brad.

    Love the podcast! So I am fairly new to the FI world. I just started reading MMM last year and have been making life changes ever since. Moving to a cheaper city, switching jobs and raising our income, walking more and driving less, cooking more at home and because of your previous podcasts decided it was finally time to get a Costco card.

    On the Friday Roundup 2, you guys were talking about Vanguard vs Schwab. I have had a Schwab account for years (before I even had money to invest). At the time, I had opened the brokerage account in order to get their checking account. I travel a lot internationally and a friend of mine had suggested the Schwab checking account for being able to withdraw money overseas. Not only do they not charge ATM fees, they reimburse ATM fees charged by the bank you are withdrawing from and they exchange at the current rate without additional fees. I’ve found it to be the best method while traveling. I always carry some U.S. dollars just in case but prefer to use the ATMs in country with my Schwab debit card for no fee transactions. Since I had their brokerage account, I’ve used their S&P 500 index fund and it has been great. I’m also planning on opening a vanguard brokerage as well and put some money in the Total Stock Market Index fund since pretty much every FI blogger I respect talks about Vanguard. But I’ll probably always keep the Schwab account too for my travels.

    Thanks for all the time and effort you guys put in to creating great content.

    Best,
    Lila

  4. Incredible how 1% or 2% can actually shave off 50% or more. Over a lifetime, investment fees can and will cost you millions if you let them. I am a DIY investor and my weighted average expense ratio (essentially only fees outside of some low flat fees in the 401(k)) is 0.08%.

    Cheers!
    -PoF

  5. Hi Jonathan and Brad,

    I am new to the FI community and love the concept. I am ready to start applying these recommendations in my life to reach FI as quick as possible. I get the idea of index funds and why they are so great and I am wondering how to best apply it to my situation. My question is:

    Is it better to max out my 401k(w 4% employer match), which is invested though John Hanckock and my only investment options are predetermined categories like aggressive, growth, conservative etc (these have higher fees, my current aggressive option is 1.64% fee).
    OR
    Is it better to contribute less money to the 401k (higher fee, less options) and invest the difference into Vanguard index funds(lower fess)?

    I suppose the argument for maxing out the 401k first would be the tax savings every year, however the fees are considerably higher. I would love to hear your thoughts!

    • Only invest as much as required to obtain all your company match, but no more. Invest the rest in a tax advantaged account with Vanguard.

  6. Hi, is there more information you have how to select the right funds when you’re not an American and live in different countries (unsure of where to retire as a Dutch 28 yr old living in Malaysia)?
    I’ve found a lot of info focussed on the US, and the non-US stuff is a bit more vague, it doesnt really go into the basics of which funds you can consider and why?
    Can’t wait to dive more into your podcast (just learned about it today).

    Daan

    • Hi Daan, We definitely started being mostly US centric, but we have received so much interest from all over the world that we are trying to figure out how to expand this message and adapt to other countries. We have a UK path to FI in the works and some international contacts that should be able to help with this.

      so stay tuned and thanks for the question 🙂

  7. I think the idea of index funds is brilliant beyond just the low-cost aspect. They’re extremely diverse yet somehow still constantly yield decent returns.

    Question: I currently have a bunch of money in a Target Retirement fund (Roth IRA). I’m considering moving this money to either and S&P 500 or total market fund, with a percentage in one of the total bond funds. Should I do this? Are there other index funds that are not stock or bonds?

    I was thinking of “hacking” the auto reallocation of the Target Retirement fund in the following matter. Let’s say right now it’s smart to invest 95% in stocks, 5% in bonds. I want to slowly reallocate to 75% stocks and 25% bonds for when I retire. I could put 95% percent of money in a stock index fund and 5% in a bond index fund. Then, when I make my regular, but smaller, contributions, make those contributions 75% to the stock index fund and 25% to the bond index fund (for instance, if I contribute $300 biweekly, put $225 to the stocks, $75 to the bonds). This will slowly move the allocation from 95% stocks 5% bonds to the 75% stocks 25% bonds.

    Of course, my numbers & percents above I just pulled out of thin air. Just a thought.

  8. Brad/Jonathan,
    I am curious about the Vanguard Index funds. My family and I are starting to put a plan together for a 10-15 year plan to reach FI. Is the money placed in the Vanguard tied up until I turn 59 like most standard IRA’s, etc? If we make this plan to reach FI prior to that age (current plan I would be 45-50) then can I at least access the interest that the Vanguard fund is generating? It’s always somewhat drove me crazy that I want to retire early but I’m placing all this retirement money in accounts I can’t touch until my later years.

Leave a Comment