Ok, so what’s an index fund?
Index fund: An electronically traded fund (ETF) or mutual fund that invests in a number of stocks or bonds automatically tied to an algorithm or formula.
Remember how I said the S&P 500 is an example of this? It automatically adjusts as new companies grow and other companies shrink – guaranteeing that you’re always invested in the largest 500 companies in the US. It doesn’t require a human to watch the news and buy or sell based on what’s happening. Instead, it auto-adjusts based on how well companies in it are doing.
We’re going to dig deep into index funds in this boot camp. As a matter of fact, that’s the ONLY thing we’re going to dig into! No stocks, no real estate no cryptocurrency.
The great thing about index funds is that they can be used to invest in just about anything else. You want to invest in real estate there’s an index fund for that. What about China, Japan or India? There’s an index fund for that. Energy, technology, healthcare? There’s an index fund for that.
Let’s take a look at the S&P 500 Index to see how this works.
Imagine for a moment you were super-rich. Not Bill Gates Rich, but more like “all of Asia and Europe combined” rich. With your newfound wealth you decide to buy the largest 500 companies in the world.
If we were to add up the total value of all 500 of these companies, the total value of them would be about 26 trillion dollars. Yes, trillion, as in 26,000 billion dollars. It’s a lot of money.
As of November 2019, the largest company in the world is Microsoft with a total value of 1.14 trillion dollars. As a percentage of our portfolio, Microsofts 1.14 trillion is about 4.33% of our total investment. Even though it’s the largest investment, it’s still only a small piece of the total.
The second largest investment would be Apple, which would represent about 4.18% of our investment. Next we’d see Amazon with 2.92% and Facebook with 1.82%.
All the way down to #500 where we’d find Nordstrom with about 0.0152% of the total holdings.
Sadly, most of us can’t buy all of the entire 500 companies in the world. What we can do instead is buy an index fund that invests in all of them for us in proportion with how large they are.
We could invest in Vanguard 500 Index Admiral $VFIAX with any amount of money we want (with a minimum of $3,000 to open an account). If we were to invest $10,000 in this fund, behind the scenes Vanguard would take care of buying pieces of all 500 companies for us.
4.33% of our $10,000 would be invested in Microsoft, or about $433. Another 4.18% would be in Apple for $418. $292 would be invested in Amazon. $182 of it in Facebook. $1.52 of it would be invested in Nordstrom. The rest would be divided between 495 other companies.
If Nordstrom went out of business for some reason, the value of your investment would fall, but it’d only fall $1.52! Even if Microsoft somehow collapsed, the value of your investment would only sink by 4.33% from that alone – although if that happened it’s likely something else is going wrong in the economy and many other stocks are falling as well.
Unfortunately, just like with stocks there are good index funds and bad index funds. Some have higher fees, involve paying higher taxes, or offer less diversification. Some index funds are outright predatory. Different companies offer funds that track the same index, but some can be good and others bad. In the case I used above with the Vanguard 500 Index Fund ($VFIAX) – that’s one of the good ones! It has a low expense ratio, low turnover, no fees or load to buy or sell it and has performed similar to it’s benchmark for many years.
Learning to analyze a fund and spot which ones should throw up red flags is an important skill and one we’ll master in this bootcamp. What’s amazing is that once you learn how to read a funds description, you’ll be able to know in moments if a fund is a low-fee, diversified index fund or if it’s actually something else.
In the next lesson, we’ll dig into what returns have historically been for investing in the stock market through an S&P 500 index fund.
Ok, let’s take a look at the top 3 takeaways from this lesson.
#1 – An index fund is a single thing you invest in, either an electronically traded fund (ETF) or a mutual fund. Behind the scenes it invests in number of stocks and/or bonds. It also automatically changes the allocation of what it invests in based on a target allocation and other criteria.
#2 – An index fund like the S&P 500 will proportionately invest in all of the largest 500 companies in the US. It invests more in the largest companies – like Microsoft, Apple, Amazon and more.
#3 – There are tons of index funds that track each index. For the S&P 500 index, there’s a Vanguard fund that tracks it, a Fidelity fund, a Schwab index and hundreds more. They differ in the fees they charge and the tax implications. Later on we’ll look into how to differentiate a good index fund from a bad index fund.
One name you’ll hear me mention a lot throughout this course is John Bogle. Bogle is most well known for two things – he created the index fund and he started Vanguard. His philosophy is exactly the same thing we’ll be learning in this Bootcamp – it’s a focus on simple investment decisions that require the least work.
His approach to investing is simple:
“Don’t look for the needle in the haystack. Just buy the haystack!”
In other words, don’t spend your time hunting through the stock market for a single stock that you think will rise in value. Instead, just invest in the entire stock market through a single index fund!
In the next lesson we’re going to dive into what kind of returns some of the most widely used index funds return.