Welcome back kids! I am so glad you made it back; this week we are going to be talking about the exciting world of index funds and ETFs (insert oohs and ahhhs here). These are great options for passively investing in the stock market without having to worry in the long run. These investments only take a small amount of research to do but it’s nowhere near as extensive as picking out other investments or single stocks. There are a number of prominent index funds that offer good returns at a low cost. Mr. Nahas, how do I invest in index funds? Don’t worry, I will take you through the ins and outs of it. Before I dive deep into the subject, I want to give you some background information first, so let’s get to work!
Stocks/Stock Market: This is where people or institutions can buy and sell stocks of publicly traded companies. A stock is equity in a company; it represents a piece of ownership. Owning a stock essentially represents you owning a piece of the business. For example, if you a bought share (unit of ownership interest) of Apple, that means you own a portion of the company. The more shares of the company you own, the larger percentage of the company you own and have a stake in. We can go into detail about stocks in a later post!
Indices: The three major US market indices are the Dow Jones Industrial Average (DJIA), Standard and Poor 500 (S&P 500, there are actually 505 companies in here, not 500), and National Association of Securities Dealers Automated Quotations (NASDAQ Composite is the index). So, Mr. Nahas, what is an index? Fantastic question! It’s basically a measure of performance of a certain group of stocks or bonds that are located in these indices. So, for example, I have three groups A, B, and C. I put companies in each of these groups, the performance of all the companies in each group are aggregated and represented as the performance in the index. The S&P 500 is made up of about 75% of the equity market, the NASDAQ is tech-heavy but has other companies as well, and the Dow Jones is made up of the most prominent, well-known companies such as Boeing, IBM, and Coca-Cola. It is important to note that companies can be in multiple indices, such as Johnson and Johnson; they are in the S&P 500 and the Dow Jones. You can’t directly invest in the index but rather buy a fund that tracks the index, and this fund is known as an Exchange-Traded Fund (ETF), but if you are buying an ETF that tracks a major market index such as the S&P 500, people just say index fund. An ETF is often a collection of (fund) securities (stocks and other investments). There are a lot of ETFs available on the market, for example, you can buy an ETF that tracks the performance of the airline industry or the hotel industry, etc. This means that most or all of the airline stocks or hotel stocks are in their respective ETF. It’s a way for you to get exposed to a certain industry without having to choose an individual company to invest in. ETFs are bought and sold just like other stocks.
Now since we got basic information out the way, we can focus on investing in index funds! So, as I mentioned before, you can’t directly invest in the index, you have to choose an ETF that tracks one of the indices. The most popular index that companies track is the S&P 500, it’s a large diversified group of companies that does not expose you to too much risk but at the same time provides you to a stable return on investment. When researching index funds, there are some things to consider:
- Fees: make sure that the fees are low, below 1% is the ideal for an index fund. There are some index funds that have 0.03% fees, also known as expense ratio.
- Management: Make sure that the management is acting in the best interest of the investors and choosing stocks that match the index. You can look at their portfolio on their website and see who manages the fund.
- Performance: Since index funds are meant to track the indices, make sure that it does actually. When looking at performance, look at the whole life of the index fund and make sure that it’s on par with the market.
Here are some of the top index funds, their tickers, and expense ratio (Tickers are a way for you to find the funds on your brokerage account). By no means is this an exhaustive list.
- Fidelity ZERO Large Cap Index (FNILX). Expense ratio: 0 percent. That means every $10,000 invested would cost $0 annually.
- Vanguard S&P 500 ETF (VOO). Expense ratio: 0.03 percent. That means every $10,000 invested would cost $3 annually.
- SPDR S&P 500 ETF Trust (SPY). Expense ratio: 0.09 percent. That means every $10,000 invested would cost $9 annually.
- iShares Core S&P 500 ETF (IVV). Expense ratio: 0.04 percent. That means every $10,000 invested would cost $4 annually.
- Schwab S&P 500 Index Fund (SWPPX). Expense ratio: 0.02 percent. That means every $10,000 invested would cost $2 annually.
Now once you have your eyes set on which index fund you want to invest in, you must have an account with a licensed brokerage. Mr. Nahas, what is that? The brokerage is kind of like a middleman, you deposit money in the account, which then allows you to buy and sell stocks or other forms of investments if they offer it. The brokerage places the buy and sell orders on your behalf. Different brokerages have different account requirements. Here is a list of things you should look for and research:
- Minimum account balance: some of them let you have an account with no minimum balance, but some require an account balance.
- Minimum investment: that usually is the price of one share of the index fund. Some brokerages like Charles Schwab is going to start offering fractional shares, which means that you can start investing without having to buy a whole share.
- Fees: Make sure that there is no fee for buying and selling stocks (this also includes ETFs).
- Miscellaneous Fees: there might be some fees for buying and selling special funds or fees for investing in an index ETF that isn’t sponsored by the brokerage. For example, buying a Vanguard index ETF through Charles Schwab.
After you picked your brokerage and the fund you want to invest in, it’s time to start buying… sort of… Mr. Nahas, what do you mean by sort of? So, kids, I have to lay some ground rules for investing in an ETF that tracks the index.
- Don’t look at your fund every day, every other day, or every week. Only look at it when it’s time to invest again.
- Don’t worry about price fluctuations that much, especially if you bought an index ETF. Below is a picture of the S&P 500 since 1960. Look at the trend of it, it has its ups and downs and ups and downs. Usually the trend is that it goes up over time, falls, and then recovers to new highs but the recovery could take time!
- When investing in index funds, you should use dollar cost averaging (DCA). The aim of this is to reduce the impact of volatility on your investment. So DCA is when you consistently buy shares of the index ETF periodically; this can be daily, weekly, or monthly. You have to do it consistently though. When it comes to index ETFs, buy in good times, and buy in bad times as well. You might even want to consider buying a little extra when the market is down. This investing money should not be touched, pretend you don’t have the money in the account. You have to let the money compound over time for you to get the full benefits.
- Another thing is to make sure that you have dividends reinvested into the fund, this helps with compounding. For those who don’t know what dividends are, it is usually cash distributed to people who own stocks of the company. So, if the company has profits and wants to reward shareholders, they will declare a dividend. So, for example, let’s say you have 4 shares of company ABC, and they want to distribute a dividend of $0.5/share, that means you will get $2 for owning 4 shares of the company.
- Go back to rules number one and two and take those to heart. You will see your ETF shares in the red, THAT IS OKAY!!! Do not panic sell or say oh crap I have to get out, especially in an index ETF. Look at the chart above and memorize it, and every time you get a feeling of selling, remember the image and the history.
Let’s imagine that you made a plan to start investing in an index ETF and have $400 saved up to invest right away. You will also contribute $100 every month towards it. In this scenario, let’s say that for the first month, you will invest $500, $400 from the saved-up money and $100 from your monthly contributions. Take that $500, split it into 4 $125 pieces and buy the index ETF on different days of that month. What I am trying to get at is to not spend the $500 right away at one time but rather spread it out over the course of the month, try to do that with the $100. In some cases, you might not be able to do this, it just depends on the price of the ETF. For example, Vanguards ETF (VOO) is $262.45 at the time of writing. In this case, you would either have to find a cheaper index fund (Charles Schwab has one that is $44 at time of writing), invest every three months in this case, or save more money each month. Regardless, just invest in the index ETF and try to buy as often as you can.
I know this is a lot to take in, but this is how you start accumulating wealth passively. This isn’t something you need to stress over if the price went down, especially if you have an S&P 500 index ETF. A time like this is a perfect example, all of the index ETFs are down from their previous highs, which means the prices are cheaper and gives you an opportunity to buy more shares at a cheaper price. If you don’t believe me, then look up what Warren Buffet has to say about this topic. I hope that I answered the question of how to invest in index funds! See you next week kids!