For most people (myself included) the path to financial independence is a journey that can take many years (or decades). Very few people achieve financial independence overnight. Sure these things do happen occasionally, but planning to win the lottery or get in on the ground floor of the next Tesla may not be the best way to hit your FIRE number. For me, one of the top tools for building wealth is index funds.
I like easy. I remember when I was growing up there used to be these infomercials on TV all the time. One that I clearly recall is for a product called the Ronco Showtime Rotisserie & BBQ. Basically you would put in your meat, set a timer and walk away. Sometime later you would come back and a perfectly cooked chicken or beef roast would be waiting for you!
Ron Pompeil was the pitch man for these gadgets. Every time he would set the timer on the rotisserie in the commercial he (and the TV audience) would say, “Set It and Forget It!” Awesome tag line that everybody remembered. That phrase alone probably made Ron Pompeil a millionaire many times over. (Sadly, he recently passed away at the age of 86.)
People like easy. People like automated. People like something they don’t have to worry much about. For me, index funds are like the Ronco Showtime Rotisserie & BBQ of investing. You set it. You forget it. You (likely) come back a lot wealthier than you did when you started. The majority of my net worth is invested in low cost index funds.
So how does this work? First off we need to define what an index fund is.
What Is an Index Fund?
An index fund is a portfolio of investments (stocks and/or bonds) that replicate (mimic) a specific market index. For instance, the S&P 500 is an index that is made up of the 500 largest publicly traded companies in the US. By purchasing an index fund that tracks the S&P 500, you are getting slivers of every single company that makes up the index!
There are tons of different index funds out there. Some track a specific sector like technology, healthcare, or finance. Others track bond or real estate indexes. Still others are total stock market indexes where you can literally buy exposure to every publicly traded stock!
Index funds are generally purchased as part of a mutual fund or an ETF (Electronically Traded Fund).
On this site, when we talk about index funds, we are generally talking about funds that track the market, such as the S&P 500 or Total Stock Market indexes.
Some of the index funds that I am currently invest in are:
- VTI – Vanguard Total Stock Market ETF
- VFIAX – Vanguard 500 Index Fund (S&P 500 Index)
- VGSLX – Vanguard Real Estate Index Fund
Ok, so what is so great about these funds? Here are my reasons for investing such a large portion of my net worth in index funds.
Easy to Manage
Index funds are super easy. You buy the fund and get all the stocks or bonds that make up the fund. When there are changes that are needed in the allocation within the fund, you don’t have to do anything.
Even easier are when you set up for automatic investing into these types of funds through your brokerage account or IRA, or when the money is automatically deducted from your paycheck for your 401K.
All you have to worry about is regularly buying funds and then holding them for the long term. History has shown us that the trend of the stock market is always in the upward direction over time! Buy, hold and forget about it!
Low Fees
Index funds generally have lower fees than actively managed mutual funds that are not tracking an index. This is because with actively managed funds, there is a highly compensated fund manager who is buying and selling stocks within the fund trying to boost the its performance. All of this costs money, which is generally passed down to the investors in the form of fees.
VTI has an expense ratio of .03%. That means that if you have invested $100K in that fund, you will be charged $30 per year in fees by Vanguard. In contrast, there are actively managed funds that charge 10-20X that (or more) in fees. These fees eat away at the growth of the fund.
The crazy thing is that most actively managed funds don’t beat the index funds over the long term!
Diversified Investments
You have heard the term don’t put all your eggs in one basket right? Well, the same is true with investing. There may be some success stories out there of people who have personally picked five or ten successful stocks and have done quite well. However, more common are people who do poorly by not being more diversified.
The beauty of index funds is you are investing in the market. With a total stock market index, you get all the companies! Big companies, small companies, medium sized companies. Tech, healthcare, finance, entertainment, travel, automotive, communications, commerce. Wildly successful companies. Some failures. But you get everything. The advantage here is you spread your risk across a wide variety of sectors, industries and companies. The net result will be a trend up with the markets.
It is possible to create a well diversified portfolio on your own. This would take a lot of research and work on your part and you would have to take care of re-balancing all on your own. With an index fund, this is all done for you and you don’t have to think about it. Simplicity at its best!
Self-Cleansing
Ok, so what happens if you have some real dogs in your index funds. I am talking about companies that are losing money, heading for bankruptcy or just plain going out of business. How are these handled? Well, over time, companies that fail or go out of business will be dropped out of the index and replaced by new companies that are growing and profitable. Again, this is all managed within the fund and you don’t have to worry about it.
For instance, last year when Tesla (TSLA) was added to the S&P 500, a company called the Apartment Investment & Management Company (AIV) got dropped out of the index. That means if you owned an S&P 500 index fund like VFIAX, you just dumped AIV and got TSLA! Ever heard of the Apartment Investment & Management Company? Me neither. But I’ll bet you have heard of Tesla. Maybe you feel like you missed out because you didn’t buy Tesla at the bottom and become an overnight millionaire when it rocketed to the top. Never fear, you can still be part of the action (and shed some of the risk) by owning it in an index fund.
The lesson is that in the entire market, there will be winners and losers. The winners will find ways to keep growing. The losers will die off and be replaced by new companies who are incentivized to become one of the winners. This is why the market keeps going up over the long haul.
Solid Historical Returns
The S&P 500 index has been around since 1926. Between 1926 and 2018, the index has averaged 10-11% per year in returns before inflation. This does NOT mean that ever year is a guaranteed 10-11% return. That is the average. There have been some very good years and there have been some very bad years. But over the long run, the index has consistently gone up with nearly 100 years of past history to give you confidence about the future.
You are not going to become rich quickly by investing in index funds. They are best utilized when they are bought and held over long periods of time, perhaps even decades. But the growth can be amazing when compounded. This is the key to building wealth even if you don’t have a lot of money to invest.
Less Temptation to Time Market
Ok, so the key to the Ronco Showtime Rotisserie & BBQ was that you set it and then forget it. That was what made it so amazing. You didn’t need to come back and keep checking or adjusting the food. You didn’t need to baste it, fiddle with the temperature gauge or anything like that. Trying to do anything before the cooking process was done actually would MESS UP the end product. You just had to walk away and not do anything to get the best result.
It’s the same with index funds. They are not trying to beat the market. They are trying to keep up with the market. The idea is that if you are satisfied with the consistent returns of the index fund you will be less likely to do something crazy like sell when the market is down. This could seriously eat into your wealth building ability over time. The best approach if you are pursuing FIRE is to hold your investments and play the long game.
So that’s my thoughts on index funds! I invest most of my net worth in them because they are easy, low cost and I can truly set it and forget it! Do you invest in mutual funds? Why or why not?