If the idea of investing is beyond you, I understand. I was too when I started investing last year. I really didn’t know where to start, so I started googling. Soon I got lost in the interwebs and landed on a page talking about low-cost index funds.
It triggered something in me – especially the low-cost part! So I looked for low-cost index funds. What did I find? Low-cost index funds generally work like the surplus market, but you pay fewer fees than any other means of trading. This means you are left with a larger share of the profits. Don’t we all want that?
One of the most successful investors in history, Warren Buffet, has an opinion on index funds. As I learned many lessons from Warren Buffett, I tend to listen to it. He praises investing in low-cost index funds. Especially when you are unwilling or unable to evaluate individual stocks, Low-cost index funds are the way to get the best return on your investment.
So let’s start by talking about the background of mutual funds and index funds, why you should also start investing in low-cost index funds, and what areas you need to pay attention to.
[Related read: investing for beginners, the how-to for investing in ETFs]
Mutual Funds 101
SO There is a difference between mutual funds and index funds. Mutual funds are actively managed funds, they aim to generate returns above the market average. By above average, I mean more than the market earns. For example, a US mutual fund would like to outperform the US stock market.
Spoiler alert: the majority of mutual funds do not outperform the market average!
Why would an actively managed fund underperform? Well, one of the many reasons is fees. If your mutual fund outperforms the market by 1% and you have to pay 2% management fees, that obviously means your return went to the fund.
In addition, Standard and Poors carried out a study among a large number of actively managed funds. They found that over a 5-year period, less than 14% of all actively managed funds outperformed the market. Hold on, over a 15-year period, less than 6% of all actively managed funds outperformed the market.
This means that in the short term, active fund managers may be able to outperform the market. BUT, if you invest for the long term, it becomes increasingly difficult to outperform the market.
Index Funds 101
We’ve talked about mutual funds, now let’s get to the good stuff! Index funds are passively managed funds. Their objective is to match the performance of an index.
You can have index funds that track the performance of:
The entire US stock marketA certain sector of the US stock market (e.g. oil)The entire global stock marketThe price of goldAnything you can think of, they’ll probably have an index fund for it!
This means you get a well-balanced selection of stocks across multiple companies or countries, without having to buy each stock individually. You can diversify your stake in thousands of companies, sectors or countries in one go!
It is very simple to create and manage an index fund. For a given index, you can find which companies, governments, or commodities are included. The index fund simply buys all the stocks included in the given index, which is why the costs are much lower.
As we have already discussed in my ultimate guide to financial independence and early retirementthe average stock market return yields approximately 9% annual return. Additionally, the average cost of a mutual fund is approximately 1.5% in investment costs. These are mutual fund fees and brokerage commissions.
BUT, many index funds only cost around 0.5% or even less! This means that you add an additional 1% return each year to your investment portfolio!
You mean I should NOT try to outperform the market?
I understand that it is very counterintuitive to think that when you’re not even trying to outperform the market, you can actually come out above average. Your extra return doesn’t come from additional actual profit on your index fund, but you put 1% in your pocket due to lower costs.
So why not just invest in an actively managed fund that outperforms the market? Well, because it is very difficult to predict in advance. Both for fund managers and for you. Because the fund manager cannot predict what individual stocks will do, even if he tries, he is not always right. Same for you, it is difficult to predict in advance which funds will outperform the market.
Low-cost index funds
Before investing in an index fund, I want you to keep something very important in mind: not all index funds are low-cost. Although some index funds charge around 0.15%, there are also index funds that charge more than 1% in fees.
Investing in low-cost index funds is the best way to keep your bottom line as large as possible. For me personally, paying 1.5% or more per year to simply maintain my portfolio is a no-no. I believe in low-cost index funds, especially if you want to invest for the long term. You want to become financially independent, save for retirement or get out of debt. This will happen much faster when you invest in low-cost index funds!
More of the profits go to your wallet when you pay lower fees. This is the #1 reason why you should start investing in low-cost index funds
How to Choose Low-Cost Index Funds
When investing in low-cost index funds, keep in mind that you should look for 3 things:
Low fees less than 0.3% (otherwise the low cost part would have disappeared) Transparency, where you should be able to see which stocks/bonds are invested in Diversified across various countries/companies
After that, decide on the desired exposure; where do you want to invest? You can go only for US stocks, only for large companies, etc. Depending on your investment objectives, you choose your exposure.
For me, I like the basis of my investments to be Vanguard All-World ETF, which covers more than 3,000 titles in 50 countries. This way the basis of my portfolio is stable, so that I already have a portfolio in many different economies and markets.
In short: how to start investing?
When you want to start investing, know that you don’t need to select individual stocks or invest in mutual funds.
Actively managed (mutual) funds only outperform the market by 6% over a 15-year period. When they take 1-2% of your profits, there isn’t much benefit left. You take more risk when you invest in a few individual stocks, where you have very little diversification. If a stock goes bust, 10% to 20% of your portfolio could disappear. Ask yourself if this is a risk you are willing to take.
Passively managed funds, or low-cost index funds, only take 0.2% to 0.3% of your profits. They track a certain index, ensuring that you get the average stock returns. Plus, diversification isn’t a problem, you can get a LOT of stocks in one low-cost index fund.
Popular index funds include VTSAX, VBMFX, VIG, FSMAX, VWRL and many others. This is not investment advice, please do your own research before investing in any of these funds.
How can I start investing? Check out these resources:
Avant-garde – One of the largest investment companies and a great place to buy your index funds. DEGIRO – A low-cost European broker that I use personally. Read my full DEGIRO Review here.M1Finance – This is a US-based company that allows you to build your own stock portfolio, completely free. No fees involved! Read the full M1 Finance Balance Sheet here.Tassels – Helps you invest your spare change and start investing small.
Are you considering (are you considering) investing in low-cost index funds?
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Founder of Spark Nomad, Radical FIRE, Journalist
Expertise: Personal Finance and Travel Content Education: Bachelor’s in Economics at Radboud University, Master’s in Finance at Radboud University, Minor in Economics at Chapman University. More than 200 articles, essays and news published on the Web.
Experience: Marjolein Dilven is a journalist and founder of Spark Nomad, a travel platform, and Radical FIRE, a personal finance platform. Marjolein has a background in finance and economics with a master’s degree in Finance. She quit her job to travel the world, documenting her travels on Spark Nomad to help people plan their trips. Marjolein Dilven has written for publications including MSN, Associated Press, CNBC, Town News Syndicate, and more.