What is Index Investing? A Beginner’s Guide

If you are a new investor and on a journey to financial freedom, you may have come across the concept of Index Investing.

But what is it exactly? How does it work? How is it different from mutual funds? And why is it such a good vehicle for all of us that want to retire early?

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What is Index Investing?

For those who just want a dry 1-sentence answer, here it is:

Index investing means that you purchase a portfolio of stocks that meet specific criteria, such as the size of the company (also known as market cap.)

Now, for those of you who want to go deeper into the topic, read on. Let's unpack what ‘portfolio' means in that 1-sentence answer:

What is a portfolio of stocks?

Portfolio is a fancy word for ‘collection.' Typically, we use the word portfolio to talk about a collection of assets which may include stocks, bonds, real estate, art, and other assets. In other words, a portfolio is a collection of investments.

Index investing shares that same definition. It is a collection of different investments.

However, it differs from a traditional portfolio in its composition. In a traditional portfolio, the assets are chosen specifically due to their characteristics and diversity. For example, you may want to own shares from several different industries, or from different companies.

In an index fund or portfolio, you do not select individual assets. Instead, the fund or portfolio invests all of the money in market indices, like an S&P 500.

Index funds can be broadly classified into two categories: passive and active.

Passive index funds track an underlying index that captures the features of many asset classes as well as other market influences. They are less volatile than actively managed funds, because the underlying index can easily be rebalanced in order to reduce risk.

Actively managed index funds, or mutual funds, on the other hand try to outperform the index.

We'll get back to the difference between passive and actively managed funds later.

How Index Funds Work

Index funds are funds that track a specific index. For example, VOO is a Vanguard Index Fund that tracks the S&P 500 index.

When you buy into VOO, your investment, your cash is then used to invest in all the companies that make up a particular index, in this case the S&P 500 index.

The companies that make up an index are selected based on their weights in the index.

Just like with actively managed mutual funds, the goal of an index fund is to make money off the gain in value of the underlying index.

While there's risk with every investment, index funds have an advantage that actively managed funds don't – they allow individuals to get a broad exposure to a segment of the stock market without having to go through the hassle of researching individual stocks. This is one of the reasons why index funds are so popular, especially in the financial freedom and early retirement community.

The life of a stock market analyst, or that of a retail day trader can be a very stressful one.

I'm convinced that a lot of people can learn the skill of researching stocks, opening and closing multiple positions ‘at the right time'.

But…

There's a certain weight, a certain pressure that you invite into your life if you choose this route.

Not only financially, but also emotionally, mentally, which can lead to physical stresses and duress.

Most of us who are on the road to early retirement can't handle all that day-in, day-out, 24/7. And that's more than okay.

You also want to keep enjoying your life leading up to your (hopefully early) retirement, and not give your brain any reasons for panic attacks.

Mitigating Risk

Did you that 95% of day traders end up losing money? At least according to The Motley Fool's article “Is Day Trading Worth It?”.

So there's a clear, inherent, and significant risk to picking individual stocks. But, after having said all that, investing into the market is still the best suited vehicle to drive you towards your destination of early retirement.

Which type of investment vehicle can severely mitigate your risk?

This is where index funds come in. Essentially, instead of having to decide for yourself in which companies to invest your next $100 in, you can choose an index fund that does all of it for you.

Different index funds have their own criteria, such as industry, region, and market cap. I even compared the S&P 500 vs the Total US Market vs the Total Global Market over here.

This is why index funds are so popular, especially in our financial freedom and early retirement community. Because all of the guesswork, all of the legwork, is done for you.

The only thing you need to do is keep investing regularly.

And remember that…

Early Retirement is Easy

As I've said before on this blog, the road to early retirement can be simple (simple ≠ easy!), but we like to overcomplicate things.

We're looking for the shortcuts, the hacks, the tricks, the “hidden secrets ‘they' don't want you to know about”.

But, essentially, it comes down to these simple steps:

  1. Spend less
  2. Earn more
  3. Save/Invest the rest

I've talked about this before on the blog, but the longest part on your path to early retirement is also the most boring one.

It's adhering to your investment strategy and…wait. There's nothing flashy about that. There are no shortcuts, secrets, or hacks to make time go faster.

Index Fund vs Mutual Fund

So, we now know that picking stocks individually is a near sure-fire way to more financial, emotional, mental, and physical stress and duress and that funds are the best way to go for the overwhelming majority of people (myself included, we just don't have the stomach to be in the stock market trenches on the daily – and that's okay).

You may have also heard about Mutual Funds.

Mutual funds are a type of investment vehicle that pools together money from many investors to make a “basket” of stocks. Mutual funds are managed by professionals who will research and pick the stocks within the fund.

Mutual funds can be considered as active investing (just not by you), whereas index funds can be seen as a form of passive investing.

Mutual funds can invest in stocks, bonds, and specialty funds like hedge funds. Essentially, the portfolio managers are the stock pickers of the fund and take their gathered information and analyses into account when making their investment decisions.

Where index funds track a ‘basket' of companies, mutual funds and their portfolio managers try to outperform the market.

There are 2 big reasons why I would advise against deferring your investing to a portfolio manager, like a mutual fund.

1. They Rarely Outperform Index Funds Long-Term

The good thing about the financial markets is that we have decades and decades of historical data.

Allow me to quote from Investopedia's article “The Lowdown on Index Funds”

Generally, when you look at mutual fund performance over the long run, you can see a trend of actively-managed funds underperforming the S&P 500 index. A common statistic is that the S&P 500 outperforms 80% of mutual funds. While this statistic is true in some years, it's not always the case.

A better comparison is provided by Burton Malkiel, the man who popularized efficient market theory in A Random Walk Down Wall Street. The 1999 edition of his book begins by comparing a $10,000 investment in the S&P 500 index fund to the same amount in the average actively-managed mutual fund. From the start of 1969 through June 30, 1998, the index investor was ahead by almost $140,000: her original $10,000 increased 31-times to $311,000, while the active-fund investor ended up with only $171,950.

It's true that over the short term, some mutual funds will outperform the market by significant margins – but over the long term, active investment tends to underperform passive indexing, especially after taking account of fees and taxes.

2. Their Fees Eat Up More Than You Think

The portfolio managers need to get paid somehow. They do this by charging fees on your total portfolio.

Their percentage fee is sounds low, with the average being between 1.4%-2%. And on a new, beginner investment portfolio that's objectively not a lot ($14-$20 in fees on a portfolio of $1000).

But, investing is a long-term game.

As your investment portfolio grows through your monthly contributions, compound interest, and the natural behavior of the market going up, so does their cut.

In the end, this could mean more than a 6-figure difference in your investment portfolio, as is shown in the image below.

index investing vs mutual funds fees

Index funds on the other hand have lower fees, or expense ratios, due to their nature of being passively managed. For example, VOO has an expense ratio of 0.03%.

Want to get a crash course on Index Investing? My friend Jeremy from @personalfinanceflub has a video course on exactly this.

Frequently Asked Questions

Can an index fund investor lose everything?

Technically, yes. Because technically the entire market can go to 0. But, because index funds track specific companies based on region, industry, and market cap, an index fund going to 0 would mean that the entire stock market went to 0…and then we have other, more important things, to worry about than our investment portfolios.

Is now a good time to buy index funds?

You've heard the saying. The best time to plant a tree was 10 years ago, the second best time is now. The same goes for buying index funds. Still not convinced that you should go with index funds or stocks?

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