Kevin runs the personal finance website Just Start Investing, where he focuses on making investing easy (just like with index investing). Just Start Investing has been featured on Business Insider, Forbes, and US News & World Report, among other major publications for his easy-to-follow writing. Check out Just Start Investing to learn the simple strategies to start investing today, as well as ways to optimize your credit cards, banking, and budget.
Taking the easy way out is typically viewed as a bad thing to do.
Usually, someone who takes the easy way out is lazy, unmotivated, and not very successful. However, when it comes to investing, taking the easy way out can be a good thing.
A great thing, actually!
Investing is not as complicated as Wall Street makes it out to be. Taking an easy approach to investing can pay dividends, literally.
The easy way to invest is with a strategy called index investing. For beginners, there is no better way to start investing than to invest in index funds. It’s low cost, effective, and (you guessed it) easy.
Below you’ll learn more about what index investing is, and why it’s a good strategy to help beginners get started.
What is Index Investing?
Index investing is an investment strategy that involves matching broad stock or bond indices by purchasing index funds.
Let’s break that definition down really quickly.
An index is simply a measure of something. In the finance world, it could be the S&P 500 or Dow Jones Industrial Average.
An index fund combines the concept of indices with mutual funds. For example, you can buy an S&P 500 index fund, or a total market bond fund. In both cases, you are buying a mutual fund that matches one of these broad indices.
The beauty of index funds is that unlike most mutual funds, they are not actively managed. You are not relying on a fund manager to pick what they think are winning stocks. The fund is designed to match a broad index (like the 500 largest companies in the US).
You avoid the fees that a typical fund manager charges, and also the risk that they pick the wrong stocks to put in the fund.
Index Funds Origin Story
Index funds were invented by Vanguard founder John Bogle.
Bogle believed that the high fees associated with most mutual funds were unnecessary. He also thought that everyday investors could benefit from simply matching the market instead of trying to beat it.
Naturally, the idea was called “un-American” at the time.
Though, people eventually warmed up to index funds. It just took some time.
Today, equity index funds and ETFs alone have over $4 trillion in assets. Below, you’ll learn why they are so popular, especially for new investors.
5 Reasons Why Index Investing is Great for Beginners
Index investing is a great strategy for beginners for many reasons, but below are the top five.
The number one reason that index investing is great for beginners is that it’s easy to get started.
The reason most people don’t start investing is that they think it’s complicated.
When using an index investing strategy, you can get started by purchasing just one investment if you so choose. Further below, you’ll find the three simple steps to help you get started.
2) Index Funds are Effective
Index funds are effective and have proven themselves over time.
For example, one of the most popular indices that index funds match is the S&P 500. Over time, the S&P 500 has a real return (after accounting inflation) of about +7%. Most investors expect that over the long term, it will continue to grow at this rate (or within two percentage points).
Will it continue to grow at this rate with 100% certainty?
No one really knows.
Though, what we do know is that the chances the entire market continues to grow are higher than one individual stock. More on that in the diversification section…
3) Index Investing is Low-Cost
Arguably the biggest benefit of index investing is that it is a low-cost strategy.
Many index funds and ETFs can be bought with an annual expense ratio of anywhere between 0.02% – 0.10%. Some funds by Fidelity are even offering 0% expense ratios!
To put it into context, with an expense ratio of 0.05%, you will pay $5 in annual fees for every $10,000 invested.
Let’s compare this to two investing alternatives: individual stocks and mutual funds.
Alternative 1: Individual Stocks
If you have a broker that offers commission-free trading on individual stocks, like Charles Schwab or Robinhood, then buying individual stocks is technically more affordable than buying index funds.
Though, the work involved in managing your own portfolio of 100+ equities is likely not worth the effort.
Plus, if your broker does not offer fractional shares, buying some stocks might be out of the picture. For example, one share of Amazon stock as of May 2020 costs over $2,000. If you are starting to invest with $1,000, or even $10,000, you likely won’t be able to create a fully diversified portfolio.
Alternative 2: Mutual Funds
Most actively managed mutual funds charge annual fees of 0.5% – 2.0%. That is huge compared to most index funds who are in the 0.2% – 0.1% range.
For example, in one year, a mutual fund with a 1% annual fee will cost you $95. Way more than the index fund with annual fees of 0.05%.
More, over 40 years, that total cost will amount to $40,000 thanks to compound interest.
As mentioned earlier, it’s much easier to buy one index fund consisting of 500+ individual investments than it is to buy each individual stock or bond on your own.
With one purchase, like a broad equity market index fund, a young investor can be relatively diversified.
Though, most people like to incorporate stocks, bonds, and international stocks into their portfolio. Which is why the 3 fund portfolio is a popular investment strategy. You can get access to each of those types of assets by purchasing and managing only three funds.
5) Widely Available
Last, but not least, index funds and ETFs are widely available.
Whether you choose to invest with Vanguard, Charles Schwab, Fidelity, or even new platforms like Robinhood, most offer a good selection of index funds and ETFs to choose from.
Just remember, the two things to look for when choosing a fund are:
- Low costs
- A broad index that fits your strategy
How to Start Index Investing
Starting to invest in index funds is easy, even for beginners!
There are three basics steps to take to get started:
1. Decide on the Right Investment Account
The first step when starting to invest is to decide which account type to open. Generally, you can choose from a personal brokerage account, or one of many tax-advantaged accounts.
Tax-advantaged accounts include Individual Retirement Accounts (IRAs) and 401(k)s, among others. They are great accounts for retirement investing, but come with limitations, like contributions limits.
Personal brokerage accounts are great to use after you have maxed out your retirement accounts, or for general saving and investing. Sometimes, starting with a personal brokerage account can be a good option despite its lack of tax advantages because it’s easy to open and there are few rules associated with them.
After you know which account you want to open, it’s time to choose a broker to open the account with.
As mentioned earlier, Charles Schwab, Vanguard, and Fidelity are all good online brokers to choose from. Though, they are not your only options.
You could also consider robo-advisors – online brokers that do most of the investing work for you.
3. Purchase Your Funds and Set an Ongoing Plan
Last, it’s time to purchase your funds and set an ongoing plan.
The key to this step is to keep it simple. Try to find 1-3 funds that provide broad diversification for low fees. Oftentimes, going with a 3 fund portfolio is a great strategy for beginners.
Once you make your initial purchase, its equally important to set an ongoing plan, adding funds or re-balancing every year, quarter, or month as you build your wealth over time.
Summary: Index Investing for Beginners
Index investing is a great strategy for beginners, and honestly for “experts” too. It’s simple and low-cost, and oftentimes outperforms some of the best money managers.
One of the best things you can do to improve your personal finances is to start investing. Today.
Trying to time the market is often a losing game. The best thing you can do is start now and stay invested for a long period of time. You now know how to start, so get to it!
My name is Derek, and I have my Bachelors Degree in Finance from Grand Valley State University. After graduation, I was not able to find a job that fully utilized my degree, but I still had a passion for Finance! So, I decided to focus my passion in the stock market. I studied Cash Flows, Balance Sheets, and Income Statements, put some money into the market and saw a good return on my investment. As satisfying as this was, I still felt that something was missing. I have a passion for Finance, but I also have a passion for people. If you have a willingness to learn, I will continue to teach.