Investing 101: A case for index funds | Few Minute Finance

Financially successful people make money in their sleep — this is how.

Luke Miller, “Few Minute Finance”

Luke Miller, “Few Minute Finance”

Albert Einstein supposedly said, “Compound interest is the eighth wonder of the world. He who understands it, earns it; he who doesn’t, pays it.” Warren Buffett put it another way: “If you don’t find a way to make money while you sleep, you will work until you die.”

A primary way successful people grow their net worth is by investing. As pension plans become rarer, workers are increasingly responsible for their own retirement preparation through workplace 401(k) plans or IRAs (individual retirement accounts). Yes, there is Social Security, but those payments alone will not cover retirement expenses for most Americans. Understanding investing is crucial to preparing for retirement, understanding the American economy, and navigating the stock market.

With help from Investopedia.com, let’s define some terms:

A stock is a tiny piece (or “share”) of ownership in a company that can be purchased. These shares fluctuate up and down in monetary value depending on the success of the company, the overall economic conditions, and other things. Some stocks pay dividends to shareholders based on company profits.

A bond is basically a loan made by a borrower, oftentimes a company or the government, to an investor (such as you). Bond shares historically don’t fluctuate in value as much as stocks, meaning they are less volatile; however, they often pay lower returns to investors than stocks.

A mutual fund is simply shares of stocks, bonds, or other investments bundled together. Investors can then purchase shares of that “fund”. An index fund is a mutual fund that seeks to duplicate performance of a stock market index such as the Standard and Poor’s (S&P) 500 Index. Investopedia defines the S&P 500 as an “index of 500 of the largest publicly traded companies in the U.S.” As such, it is a very good performance indicator of the U.S. stock market as a whole.

Critical to investing is diversification: don’t put all your eggs in one basket. If your retirement is solely invested in stock from one single company, and (worst-case scenario) that company performs poorly or goes out of business, the value of your stock could plummet, and your retirement is now worth pennies on the dollar. Not good.

While it’s possible to earn high returns by buying and selling single stocks or shares of actively-managed mutual funds designed to beat the stock market’s return, most investors (myself included!) lack the stock-trading prowess and timing. Warren Buffet and John “Jack” Bogle, the founder of Vanguard, recommend investing in simple index mutual funds, because trying to “beat” the stock market is, according to Bogle, akin to “looking for a needle in a haystack.” He recommends “buying the haystack”: use index funds. Each share of an index fund that tracks the S&P 500, for example, represents the “whole” stock market, as it were, spreading out investment risk over 500 stocks instead of one single stock.

Furthermore, publisher Stock Analysis, using data from a 2020 S&P Dow Jones Indices report, concluded that ”as a whole, 78-97 percent of actively managed stock funds failed to beat the indexes they were benchmarked against over ten years.” Even in the 1990s, Vanguard’s Bogle reached the same conclusion in his book “Common Sense on Mutual Funds”: index funds will outperform about three in every four actively-managed mutual funds over time.

Author and economist Burton Malkiel describes it this way: “It’s true that when you buy an index fund, you give up the chance to boast at the golf course that you picked the best performing stock or mutual fund. That’s why some critics claim that indexing relegates your results to mediocrity. In fact, you are virtually guaranteed to do better than average. It’s like going out on the golf course and shooting every round at par. How many golfers can do better than that? Index funds provide a simple low-cost solution to your investing problems.”

And “better than average” is quite good, as it turns out. Despite occasional short-term volatility, the S&P 500 Index has produced an average overall return of 10.2 percent since it was created in 1926, per data from Charles Schwab’s publication “OnInvesting”. That includes the Great Depression, the Great Recession, and numerous other downturns. Invest for the long-haul and ignore all the emotional stock market “noise” from the media!

Since index funds aren’t seeking to beat the stock market for their investors and require very little management, the fees (“expense ratios”) charged by firms to invest in them is comparatively low. Fidelity Investments even has a line of funds called ZERO with no fees and no minimum investment. This means anyone can invest – for retirement or otherwise – regardless of income.

I know people who removed their investments from the market earlier this year amid the COVID-induced market drop. They were afraid. Nobody likes watching their investments sharply decrease in value during a downturn. Some never re-invested in the market, and their retirements are now worth a fraction of what they once were. Had they left their investments in the market, untouched, they would likely have already recovered all the lost value. As of Nov. 18, Fidelity’s 500 Index mutual fund has returned 12.26 percent year-to-date, including the market crash in March.

Dave Ramsey likes to say the only folks who get hurt on a roller coaster are the ones who jump off halfway through the ride. Stay the course!

Investing in index funds that track the broad stock market is a time-tested, successful strategy. Don’t simply take my word for it, though. Test for yourself what we have examined today. Some of my favorite books on the subject are “The Little Book of Common Sense Investing” by John Bogle and “The New Coffeehouse Investor” by Bill Schulteis. For a more academic read, try Bogle’s “Common Sense on Mutual Funds” or Burton Malkiel’s “A Random Walk Down Wall Street”.

Lastly and most critically, get a financial advisor. I cannot overemphasize this. I consult with ours regarding best practices and future plans; his advice is invaluable. It may cost you some money for the service, but wise counsel can keep you from making costly investing mistakes. There are considerations such as fees, expense ratios, turnover, taxes, short/long term capital gains, losses – don’t navigate these alone.

Actions you can take today, right now: if you’re out of debt (except your mortgage, if you’re a homeowner), begin contributing to a retirement investing plan today, such as a 401(k) or IRA, with the help of a trusted financial advisor. If you’re unsure where to start, go to Dave Ramsey’s website (daveramsey.com) and look for “smartvestor”, which will direct you to vetted financial advisors in your area.

I’ll leave you with this illustration: if 10 years ago you had invested $10,000 in the Fidelity 500 Index Fund from Fidelity Investments (ticker symbol FXAIX), which is designed to mirror performance of the S&P 500 stock index, today it would be worth $33,947, without even lifting a finger – no contributions, no additions, just pure compounding growth – much of which happened while you were asleep.

Luke Miller is passionate about helping others succeed in their finances, careers, and lives. A fourth-generation aviator, he is a pilot for a Seattle-based major airline. Luke and his wife live locally in Enumclaw. This article is based on the author’s opinions and recommendations alone and is not intended to be a source of investment advice.




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