What is your retirement money invested in? The safest and smartest investment is a stock index fund.
There are a lot of misunderstandings about investing in the stock market. Most are afraid and wary of this subject.
Try bringing up the subject with your spouse, or family, or friends. You’re bound to get concerned looks and questions like, “Isn’t that risky?”
They imagine trading stocks is like gambling large amounts of money at a casino. You can’t play against the smart, savvy Wall Street men – they’ll outsmart you every time!
Of course, it’s not quite like that. A stock index fund is not day trading. There’s no big, electronic screen with red and green numbers. There’s no well-dressed men sweating, picking up phones, and slamming them down.
Others are convinced they can trade stocks better than an index fund. They attempt to do research, but are unsure which stocks are best. How do you know if a company will succeed or fail? Which stocks should you buy or sell?
The answer to these fears and doubts is a stock index fund. This clever invention all but guarantees return. They have low expenses and are easy to manage.
In fact, Warren Buffett advises investing in a stock index fund:
“Over the years, I've often been asked for investment advice, and in the process of answering I've learned a good deal about human behavior. My regular recommendation has been a low-cost S&P 500 index fund” – Warren Buffett
In this post you’ll learn what a stock index fund is, why you should invest in one, and how to get started.
Let’s dive in.
What is a Stock Index Fund?
Stock (sometimes called a share) is a piece of a company that you own. If you have stock, you have a right to a portion of future profits the company makes. You also have the right to attend shareholder meetings and vote on company decisions, though you’re not obligated to.
The profits you receive from stocks are called dividends. Theoretically, if you own stock you can make profit for the rest of your life. However, companies do poorly from time to time, and dividends fall.
Analysts and financial advisors try to predict which stocks will do well and which ones won’t. They watch the news, ready to buy Apple’s stock when they announce a new phone. They’re ready to sell when a CEO has a public scandal.
The truth is you can never tell if a stock will do well in the future or not. They are too many variables. Besides, it’s stressful and induces anxiety.
A stock index fund looks at the long term growth of the entire stock market. Instead of worrying about which stocks will do well, a stock index fund invests in all of the stocks.
This clever invention operates on the theory that the collective stock market always wins. Meaning, even if some stocks do poorly, the overall performance of the stock market nets worth.
A stock index fund mirrors market indices. Let’s explain the difference between a market index and an index fund.
A market index records data on many stocks. These indices (the plural of index) are not investing in stocks; they are recording the rise and fall of stocks.
There are many market indices, but let’s look at a famous example: The S&P 500 (Standard and Poor’s). This index tracks the top 500 companies in the United States.
Now let’s look at index funds.
Index funds base their decisions off of these market indices. A popular index fund called the Vanguard 500 Index Fund bases their decisions on the S&P 500.
The Vanguard 500 Index Fund therefore copies the S&P 500 market index.
The Vanguard 500 Index Fund automatically buy all of the stocks, in the appropriate ratios, of the companies listed in the S&P 500.
Whenever the S&P 500 adjusts their index, the Vanguard 500 Index Fund also adjusts its portfolio.
You can track the Vanguard 500 Index Fund here. Here’s a screenshot of the fund’s recent activity:
If a company drops below the top 500, the S&P 500 records that. Then the Vanguard fund sells all of that stock, and invests in the new company now in the top 500.
Obviously not every company succeeds, but the collective of companies will. So if you invest in the 500 best companies, you will eventually, always make profit.
Pretty clever right? Let’s explain some more benefits.
Why Choose a Stock Index Fund?
There’s a lot of ways to invest your money – bonds, properties, high interest savings accounts. What makes a stock index fund different from these other options?
Stock index funds are passively managed. This means there’s less of a human component in buying and selling stocks.
As explained earlier, stock index funds simply copy market indices. There’s no guesswork, no research, and no magic formula to follow. All a stock index fund has to do to buy the stocks listed on a market index.
Software can do most of this work. Therefore managing a stock index fund is very easy, and doesn’t require a lot of overhead.
As of April 2019, the Vanguard 500 Index Fund has a 0.03% expense ratio. If you invest 10,000 dollars, 3 dollars will go to overhead cost every year.
Compare this to actively managed funds, which can be as high as 1.5%.
Stock index funds also have low turnover rates. Meaning they don’t constantly trade stocks, but rather do it sparingly and rarely.
In some cases, all an index fund needs to do is rebalance their portfolio every 6 months to match its market index.
This keeps costs down tremendously, since buying and selling stocks can incur capital gains taxes. By having lower turnovers, it’s cheaper to manage a stock index fund.
Ultimately, that means it saves you more money.
Simple strategy that never changes
There are no surprises with a stock index fund. Other investments may require a change of strategy. For example, if property value goes crazy, you may be forced to sell properties you own.
Actively managed funds may change their style or philosophy over the years. Perhaps they stop investing in tech companies and start investing in oil companies.
Or perhaps your old fund manager retires and a new manager takes over.
That comes with uncertainty about the future. But this doesn’t happen with stock index funds.
The strategy is always the same – follow the market index and always adjust stocks to match the index.
This tactic remains the same for any manager, any time period, and in any situation.
You don’t have to worry about overcoming new challenges or answering future questions.
The strategy is set in stone.
I won’t pretend there aren’t safer options. Investing in government bonds is widely considered safer than what I’m recommending.
However, investing in a stock index fund is safer than a lot people imagine.
As explained earlier, certain companies may do poorly, but the collective nets profit over time.
The reason is that the top companies are always competing, adapting, and trying to succeed in their industries.
With a stock index fund such as the Vanguard 500, you’re not betting your money on a particular company, but the U.S. economy.
Experts have tested this method for forty years. As previously mentioned, this is Warren Buffett’s common suggestion when giving advice on investing.
How to Invest in a Stock Index Fund
Investing in a stock index fund begins with research. You may want to consult with your financial advisor.
Then you must choose a fund. Not everyone will select the same one.
Some index funds are based on the Dow Jones, which only tracks the 30 largest public companies.
On the other hand, you can invest in a fund that tracks the entire US stock market. An example is the Vanguard Total Stock Market Index Exchange Traded Fund (VTI).
Various funds offer different levels of exposure to risk, overhead costs, and returns. So start with research.
One option to consider is what Warren Buffett recommended – a fund that tracks the S&P 500. Earlier I mentioned one – The Vanguard 500 Index Fund.
You can learn more, and start investing, in this fund at Vanguard's website. There is a minimum investment of 3,000 USD.
For several years, many have considered Vanguard a trusted institution.
Alternatively, you can invest in stock index funds for other countries.
Historically speaking, the United States has been one of the most business-friendly nations on the planet. So there’s wisdom to particularly investing in U.S. stock.
You can also use other companies to manage your index fund(s), such as Betterment.
Invest Well to Retire Well
Going into retirement with a chunk of money in a stock index helps tremendously.
They regularly pay dividends. You can additionally take out more money, and slowly deplete your funds.
If you calculate your money, and pace yourself, you can retire knowing you’ll have a steady supply of money.
And you won’t have to work ever again.
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