Index Funds: A Beginner’s Guide

As you start to read through the invest early section of the blog I want to make it clear that my investment recommendations are based on what I personal do. I will never recommend a stock of a particular company to buy or any type of specific asset. This section is more of an educational guide which you can use to do your own research after or bring to ask questions if you have a financial advisor. If you are on the long-term proven path to wealth you should have some money invested in index funds. There is no better way to build your early retirement nest egg than to amass your money in a small selection of proven index funds and watch your net worth grow.

Index funds are simple at heart but are still confusing to the uninitiated. So, let’s go through the basics of the index fund and how you can take advantage of their proven track record.

What is a Stock Market Index?

The first question that needs to be answered in regards to index funds is, what is an index? When the most famous US stock exchange opened its doors for the first time in 1792, the New York Stock Exchange (NYSE), it quickly became evident that there would need to be a way to measure the quality and overall health of the stock exchange. Thus the stock market index was born.

The stock market index is a weighted average of a selection of stocks that are generally accepted to represent a market in whole or a market segment. The scope of the index is designed to represent the market segment so that your personal fund or stock performance can be tracked against the standard. This helps to make decisions on asset allocation and when to buy and sell, but as you will soon find out, buying and selling is the best way to lose money.

Major Stock Market Indexes

Some major stock market indexes are presented in the table below with index, target market segment, and the number of stocks included.

Index Market Segment Number of Stocks
Dow Jones Industrial Average US Large Cap 30
S&P 500 US Total Market 500
Nasdaq Composite Index Technology All Nasdaq Stocks
Russell 2000 US Small & Mid Cap 2,000
CRSP US Total Market Index US Total Market ~4,000

The above selection of index funds represents primarily US indices. However, because most large companies these days are international, these US indices give some view into the world economy as a whole.

The Dow Jones Industrial Average, better known as the DOW, is the oldest of the indices, developed in 1896 and is made up of the 30 largest companies on the NYSE. The S&P 500 seeks to improve on the Dow by adding another 470 of the largest stocks to the mix. The indices are re-evaluated on a regular basis to include and exclude stocks that have broken into the defining metrics of the indices. Basically, the indices are defined by the distribution of stocks on the market and not by the individual companies.

What Are Index Funds?

So now that we know what a stock market index is, understanding an index fund is very simple. Simply put, an index mutual fund tries to mimic the stocks, allocation, and performance of a specific stock market index. The mutual fund is a collection of stocks that is approximately the same as the index it is mimicking and the job of the fund manager is to maintain the allocation as stocks rise and fall in price.

Because of the underlying principle of mimicking an index, index funds do not need the high turnover rate (buying and selling of stocks by the fund manager) to maintain the allocation and performance compared to the index. This gives index funds the lowest expense ratios in the industry with rates well below the 0.1% range for the most passive of index funds.

Index funds are available for just about every index imaginable, from obscure to mainstream and from small-cap to total-world.

Fee Minimization

When looking to pursue financial independence and grow your nest egg for retirement, the low cost of index funds allows you to minimize the fees. You can try to build a portfolio of stocks to mimic an index fund yourself, but the trading fees alone will cost you more than buying into a mutual fund with a low expense ratio.

When buying into a mutual fund, you will want to be sure it is labeled as NTF or no transaction fee. This allows you to buy the fund as many times as you want without ever paying a commission to buy it. Funds are available with NTF generally from the companies that provide the funds in the first place. The 2 most popular index fund companies are Vanguard (my personal favorite) and Fidelity. Both of these companies allow you to invest your money with them and buy all of their funds for free if you invest with them. Investing directly in the index fund companies makes it incredibly easy and convenient to save money on investing.

However, you can also invest on other trading platforms like Ally Invest, Scottrade, E-Trade, etc. and look for NTF mutual funds.

Investing In Your First Index Funds

We now know that investing directly with the index fund company is the best way to go when buying your index funds. However, that is not the end of the story.

In order to invest well with index funds, you need to decide on an asset allocation that is desirable for you. Once you have decided on the asset allocation it is time to invest in your index funds. Most funds have a minimum investment that can range from $500 up to $10,000 or higher. The cheapest funds have higher minimums, but at Vanguard and other investing companies, you can switch to the cheaper fund for free once you have enough money.

Select your index funds based on the index you would like to track and expense ratio. Minimizing the expense ratio needs to be a major factor in your decision because this only eats away at potential gains.

If you would like a list of index funds to invest in, here is what I have invested in:

Index Fund Name
VTSAX Vanguard Total US Stock Market
VTIAX Vanguard Total International Market ex US
VEMAX Vanguard Emerging Markets
VGSLX Vanguard REIT Index
VBTLX Vanguard Total US Bond Market

Currently, I own only VTSAX and have sold off everything else to keep it simple.

Continued Investing in Index Funds

Okay, so now you have bought a fund, or 2, or 3. Now it is time to continue the push to invest on a consistent basis. Each and every month you need to put aside money to invest into your index fund/s. The most important part is:

Invest every month. Do not try to time the market. Trying to time the market will result in losing money.

The power of the index fund comes when you invest every month without looking at the market. Just put your money in your funds and let the talking heads on the news talk. Don’t listen to all the chatter. The chatter is designed to make news, not to help you in actually making money.

If you want to make money in the stock market you have to: Keep It Simple Stupid. KISS

By keeping it simple, by keeping the emotions out of your investing, you are able to let your money go into the stock market and grow. When you try to time the market by buying and selling funds on a frequent basis, then you will end up on the losing end of market timing.

When the stock market goes down, invest.

When the stock market goes up, invest.

When the stock market is flat, invest.

As Jack Bogle (the founder of Vanguard and major proponent of index funds) says:

“Time is your friend; impulse is your enemy.” ~Jack Bogle

If you want the benefit of compound growth, follow Jack’s advice. Over the long haul, the stock market will continue to rise. It will continue to make money because creative people are making desirable and useful products for the world. The stock market is based on actual companies, and if you believe that they are truly making value, then the stock market will continue to go up in the future.

One Last Note: ETFs

ETFs or exchange-traded-funds are essentially the same as mutual funds. They are generally the same composition as the matching mutual funds and are offered at the expense ratio of the lowest price mutual fund. The difference is they are traded on the stock exchange and price fluctuates throughout the day. They also only are available in whole shares, so you must buy amounts equivalent to whole shares.

Personally, I like to invest even, round number amounts each month, like $1,000 or $2,000 and that is not possible with ETFs. Besides that caveat, they have the same risks and rewards as the equivalent index mutual funds. ETFs are even available at the normal trading houses with no transaction fee to make them essentially the same as mutual funds with the index fund company. In my next post I will go into more details about them.


Do you invest in index funds? Which ones do you invest in? Start the discussion in the comments!

“Never spend your money before you have earned it.”
– Thomas Jefferson –

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