Are you relatively new to financial independence and investing? Sometimes, you’ll see people throw around terms casually that might not be immediately clear. In this post, I’m going to provide a quick overview of a very common topic in the financial independence space: index funds. What is an index fund and why would I use it?
In a recent conversation with a friend, I was recently reminded that concepts many of us consider straightforward can be confusing for new financial independence seekers. After I mentioned that the majority of my net worth was in index funds and then quickly moved on, he interrupted and asked, “What are index funds?”
Investing is sometimes (intentionally) made to seem complex and difficult. This keeps people away and/or enables “advisors” to make money off the confusion and anxiety.
Index funds are a great way to invest effectively and simply. I’ll provide a quick overview and share some resources at the end if you want to go deeper.
(FI Basics posts are not intendend for those already familiar with the concepts. If that’s you, you can give this one a skip.) Check out other FI Basics posts here.
What Is an Index Fund?
Stock / Share
Let’s start with the basic building block that (nearly) everyone is familiar with: a stock. A company stock is an investment in that company. To buy company stock, you buy a share or shares of that company. For example, if you own a share of Coca Cola, or “stock in Coca Cola” you own a small percentage of the company.
You can track how your stock is performing simply by paying attention to the price of each share of that stock. If the share costs more than you paid for it, it has “gone up.”
Index
Sometimes, people want to track how a group of stocks perform. If the group is small, this isn’t too challenging. For larger groups it gets complex. In this case, the companies are grouped together to measure the overall performance. These combinations are called an “index.”
Indexes are created to track different types of companies based on size, industry, or even the entire stock market.
Three of the most well-known indices (yes, that’s the plural of index!) are:
The Dow Jones Industrial Average: Tracks stock performance of 30 large American companies.
The S&P 500: Tracks 500 of the largest US publicly traded companies.
The NASDAQ Composite: Tracks 3300 common equities.
If you’re interested in going further down the rabbit hole of indexes you can read An Introduction to US Stock Market Indices.
Fund
An index tracks the group of stocks and cannot be traded directly. You can’t directly buy “The Dow” for example.
The fund portion of “index fund” refers to a mutual fund or exchange-traded fund. These allow you to buy a group of stocks.
If that group of stocks tracks an index, then it is an index fund.
Pretty straightforward, right?
An index fund owns a group of stocks that are tracked together.
Vanguard Total Stock Market Index (VTSAX) is the the most commonly mentioned index in online personal finance. But it is far from the only index fund.
(Note: The letters in parentheses after the fund are called a ticker symbol.)
A few other examples include:
- Fidelity Total Stock Market (FTSMX)
- Fidelity Zero International Index Fund (FZILX)
- Vanguard 500 S&P 500 Exchange Traded Fund (VOO)
- Ishares Russel 2000 Small-Cap Index Exchange Traded Fund (IWM)
- Schwab Large Cap Exchanged Traded Fund (SCHX)
You can look up each index fund to understand what the fund is actually tracking.
Why Would I Use One?
Okay, so an index fund is literally just a fund that tracks an index of stocks. Why would you buy one?
Simplicity
When you buy an index fund, you are buying hundreds or even thousands of stocks with one transaction. This is obviously much easier than trying to buy lots of individual stocks. I’m a big fan of keeping investing simple.
Lower Risk
Owning one stock is risky. The chances of a single stock dropping drastically, or even going to zero, are higher than an entire group of stocks doing the same.
Spreading out the number of stocks you hold is commonly called diversification. An index fund allows you to own a greater number of stocks without buying each individually. This lowers your risk of loss.
(You can and probably should diversify across asset classes too – that is, hold other investments in addition to stocks. But that is a topic for another post.)
A total market fund, for example, tracks the entire US stock market. In the event of a major financial crisis, many stocks will drop drastically. But, it’s unlikely that the entire market drops to 0. If that happens we have much bigger problems than our investment returns.
Solid Returns
While you are unlikely to see your money “10x” quickly with an index fund, you can generally count on solid consistent returns over time. The average annual return for the S&P 500 since inception is about 10%.
Historic returns don’t assure future returns. Yet, when you own a broad-based index fund you are betting on a large part of the market. I feel confident that the US market will continue to perform well in my lifetime.
You may not get the upside of owning an individual stock, but you also don’t have the extra risk. Combining lower risk with the likelihood of solid returns works for me.
Low Fees
A big advantage of many index funds is that they are passively managed rather than actively traded. This works out to lower fees – usually significantly lower fees.
That means over time an index fund will come out ahead even if they slightly underperform an active fund because you aren’t bleeding money to fees. In reality, very few funds consistently beat the total market. That makes market index funds very attractive to simple investors.
In fact, the low fee is perhaps the largest advantage of an index fund.
Combine lower risk, solid returns, and lower fees and you can see why index funds are a staple of many FI portfolios.
How Do You Get Started?
A product with a decent risk profile, solid returns, and low fees sounds good? Even better, index funds are common accessible products.
If you are an educator with access to a 403b or 457b you might even find index funds among your options! (Unfortunately, too many providers don’t include these low fee options.)
If it sounds like index funds fit your investing preferences, you can buy them through most brokerages. The most popular brokerages with solid track records and a good history of keeping fees low are:
Learn More
If you are interested in learning and understanding more, these three sources dramatically increased my understanding and convinced me of the power of index funds. They helped me avoid the ego move of trying to increase my returns through playing with individual stocks:
Free learning, and a great read: JL Collin Stock Series
Two great books (Affiliate Links)
Summary
Index funds are investment products that hold a group of stocks tracked by an index. They provide diversification, solid returns, and generally lower fees.
I’m an index fund investor. I hold:
- Vanguard Total Stock Market Index Fund (VTSAX) in my 403b and brokerage account
- Fidelity Zero International Index Fund (FZILX) in a brokerage account for some international diversification
- Blackrock Russel 3000 Index Fund was the only broad market index option offered in my 457b.
Only you can decide if index funds are right for you! If you were unclear about index funds, I hope this quick and simple overview helped.