What Is An Index Fund? Index Investments For Beginners

Are you trying to achieve financial independence to retire early as your friends have? If you are then you have likely heard of long-term investing with index funds, mutual funds, or ETFs. How index funds work is they aim to equal their market price instead of trying to be ahead of it. With the market indices being bull for the past few years they have become more appealing to younger investors starting retirement planning.

More millennials every day are learning how to invest in market funds and it’s paying off. Millennials are making it their goal, according to a recent NBC News article,” a recent T.Rowe Price survey, 43 percent of millennials expect to retire before the age of 65, while a Bankrate survey found that millennials cited age 61 as the ideal age to bid adieu to their careers.”

Index funds work differently than mutual funds. With index investment, the account is not actively managed by a brokerage company but passively managed. Being passively managed allows the account’s data to be available constantly to the investor so quick decisions can be made after the day’s trading is over.

You cannot make index trades during the trading day because the bids must be made when the price is stable and your fund manager can take out their commission and calculate your earnings.

If index funds are used smartly they will become long-term investments and be left alone for at least one year so they aren’t charged with the short-term capital gain tax. It is optimal for these accounts to be held over decades for them to reach their full potential with compounded earnings.

When investing money into your fund the money is spread out and invested in each one of the companies in the index. The companies differ by their size and value to the market and they each carry a different weight or percentage of the portfolio.

The financial manager is responsible for investing your money across all the stocks using a formula unique to each financial company’s index fund. The formula is just the weighted average they place on each of the stocks in the specified market.

Your investment gains and losses will follow the market trends of your fund’s specific market index.

These indexes include the S&P 500, Dow Jones Industrial Average, and Nasdaq.

The percentage of each stock, or its weighted average, is usually measured by its impact on changing the entire index price.

You’re allowed to buy shares or put whole dollar amounts down when buying into the funds of your choosing. I would avoid index funds that have high commission fees as the managers aren’t the ones determining the value of your account, but the market.

How to Make Money Investing In Index Funds?

Many financial advisors swear against index funds. Index funds have cut them out of being able to trade your money on the market and this means fewer fees for them to collect.

Index funds are much cheaper than the average brokerage fee and are a low-cost/risk way to get into buying funds. The good news is that history shows that on average the market increases by 2%-5% every year. The last few years have been above double digits in percentage increase and retirees’ annual annuities have been large.

There are years when the market crashes but investing in index funds is a long-term process and the market is always going to do what it does, go up and down. Index funds may lose money or make very little if you hold them for just a few years or less. The important thing to remember is that the market index over time has been rising since its creation.

I’m not saying you can’t lose money on index funds, just that the risk is reduced because of the diversification of the investment.

In good years, the market may raise anywhere from %10-%15.

I have started investing in the Vanguard S&P 500 ETF index fund and am putting 60% of my savings into it from each pay period. The higher the dollar amount you can invest in an index fund of your choice, the better.

Compounded Earnings

After having your money invested into index funds for a year your initial investment should raise at least a few percent. That few percent of earning will raise the total amount and then next year the amount will raise even more.

Using the long-term retirement investment strategy you will see the account compounding over time, making more money each year.

It works like interest but there are still chances where the market index for the year can be lower than the year before and you will lose some money. But if you get scared and pull your money out then you’ll be mad at yourself when the next year the index returns 20%. You just never know.

So, it’s important to add money to the index fund account throughout the year and leave it alone.

Over time compounded earnings will grow your account and you will start to receive enough passive income to achieve your goal.

Why Are Index Funds Important to FIRE?

People throughout the FIRE (Financial Independence Retire Early) community praise index funds. Most believe they are a necessity to achieving financial independence.

If you’re attempting FIRE it’s important to save 40%-70% of your income every month to put into an index fund.

The fund will grow over time and it will reach a point where you make enough money to start living off the long-term capital gains of your account.

This is the point where your index fund account starts generating enough passive income to cover all living expenses. This is when most people choose to retire early, declare success, and pursue what they want to accomplish in life.

The Stock Market’s Historical Rise

Index funds are attractive to the FIRE lifestyle because they work well long-term, and are backed up through historical data. Even though there have been market crashes, which are indeed dangerous, the market always picks back up again. Long-term investors like Warren Buffett know this and this is why he invests in index funds.

The market index charts below show information from when the market indices opened to the present. You will get a good idea of why it is smart to bet on the market for long-term investing.

All the above charts in the slideshow are sourced from StockCharts

Index Funds vs Mutual Funds

Mutual and Index funds are different from each other in many ways. Mutual funds act like a company that receives money from investors and then buys up stocks to build a portfolio. This portfolio is organized and diversified by a financial fund manager. His job is to actively move the money in that portfolio to keep it above the market.

The mutual fund manager’s goal is to select stocks to profit and stay above the market. The managers consistently trade the shares in the portfolio opening a possibility for mismanagement and loss as well.

Mutual Funds are also hard for the investor to monitor because they are changing as the market changes.

Because they are actively managed, mutual funds also have higher commissions and fees.

The difference between the funds is index wants to track the market, while mutual funds try to beat the market. This makes mutual funds riskier but also gives a higher chance of being more profitable in the short-term.

Data has shown that of all actively managed domestic funds only 1 in 20 was able to beat their market index. While any index funds with decent stock averaging and weighting hover around the market index with ease.

Investopedia came out with an article about a 2018 SPIVA study where they concluded that “Over the past five years and the past 15 years, no more than around 16% of managers in any category of actively managed U.S. mutual funds beat their respective benchmarks.”

Over the past five years and the past 15 years, no more than around 16% of managers in any category of actively managed U.S. mutual funds beat their respective benchmarks.

– How to Choose the Best Mutual Fund by Investopedia

For me the evidence is clear, stay away from mutual funds unless you know the manager very well and trust him with your money more than letting the reliability of the market consistently make you small amounts of money over long periods.

Not all mutual fund managers have a difficult time beating the market though and some go on to have great careers. Statistics do show that over a 20–30 year period even great fund managers will have years of bad luck. This is why for all long-term investments I let the market do its thing over time.

Index Funds vs ETFs

The main difference between ETFs and index funds is that ETFs trade like stocks during trading hours. The latter must wait for the closing bell each day to trade.

ETFs can be lower cost compared to index funds, but their commission and fees are like normal stock and therefore higher. Some ETFs track indices similar to the large index funds so they can trade during market hours.

ETFs offer another thing index funds do not have. The ability of flexibility and being sold by the share during market trading hours allows a more accurate price.

Index fund values calculate after the trading day and factors are known only to the brokerage manager affect the share price.

ETF liquidity is lower than an index fund because index funds guarantee a buyer through the fund manager. While ETFs rely on available shares, volume, and trades like a normal stock.

The market’s Tracked By Index Funds

One thing all index funds have in common is they are trying to match a certain market index. Other index funds may follow companies in the Dow Jones, Nasdaq, foreign market, and some track the whole market.

The index funds I recommend for beginner investors would be funds tracking the S&P 500. It includes the 500 best-performing and consistent stocks from different sectors of the market.

Most Popular S&P 500 Index Funds

The S&P 500 index companies make up a total of %75 of the stock market’s total value. It’s diverse and profitable and the funds below have been the most profitable in recent years.

Vanguard 500 Index Fund Admiral Shares

Rating: 5 out of 5.

• Symbol is VFIAX
• Founded in 1976 and has long been one of the top index fund performers.
• Last 10 years there was a return rate of 14.3%
• Commission Fee of 0.04%
• Minimum Investment of $3000

Fidelity 500 Index Fund

Rating: 4 out of 5.

• Symbol is FXIAX
• Founded in 1988, and investment minimum was recently removed
• Lifetime annual average return rate of 10.22%
• Commission Fee of 0.015%
• No Minimum Initial Investment

Schwab S&P 500 Index Fund

Rating: 3.5 out of 5.

• Symbol is SWPPX
• Founded May 19, 1997
• Lifetime annual average return rate of 7.77%
• Commission Fee of 0.02%
• No Minimum Initial Investment or Account Balance

While the S&P 500 offers the most profitable 500 companies, many other index funds include different companies.

There are also foreign market funds that can be just as profitable by tracking emerging markets. Here is a list of some others for you to check out and learn about:

Popular Financial Funds

• FNILX — Fidelity ZERO Large Cap Index
• VIVAX — Vanguard Value Index Fund Investor Shares — (Mutual Fund)
• VFISX — Vanguard Short-Term Treasury Fund Investor Shares — (Mutual Fund)
• VTSMX — Vanguard Total Stock Market Index (Total-Market Fund)

Since all index funds match the market and the market increases over time, they’re safer bets than individual stocks.

ETF index shares have the benefit of tracking the market but with the versatility of a stock share. As you know, stock shares are good for short-term investing when the market is on a bull run.

Mutual funds are only worth it if you know a very good financial fund manager who is consistently beating the market. However, if I find someone like this I wouldn’t leave my money with them for more than 3–5 years. In other words, all fund managers have bad years and there are employment changes all the time.

I don’t even use a savings account. I put all extra money into my Vanguard Admiral Shares Index fund. Over the past four years, I’ve seen an average 11.4% increase since its opening.

The index funds above are only a small selection of available funds you can invest in.

Index funds mean you can invest and wait but you must check back in to look for big changes in the market.

Final Tips On How To Invest In Index Funds

1. Your index fund should be tracking the price of its market. If it’s not, you might want to reevaluate the fund you use and what financial manager the company has.
2. A few years after investing it’s important to check that you are making a positive AVERAGE annual return. The positive average annual return is the whole point of index funds and compounded earnings.
3. Don’t remove your money early if you have a negative return for one or two years. Remember you’re playing the long game holding the investment for 20 to 30 years. I guarantee that there will be years of positive growth ahead to counteract what you lost.
4. Make sure you’re checking with your financial managers every few months to make sure they still have good leadership. Make sure they haven’t raised the expense rate or commission fee.