What is an index fund? And how do I get started with it?

[mrssavesalot]

Hi all,

I'm new here. My husband and I are new to mustachianism, and just finally managed to get 10k saved in the bank. Since we are in our mid/late 30's, we're very eager to start building wealth for our future goals (a paid in cash urban house/condo and fully funded retirement).

Please don't hit me too hard, but exactly what are these index funds I keep hearing about, what sort of related fees do I need to plan for, and how much do I need to get started anyways.

Also, yes, I know traditionally people have a 401k, and Roth IRA, but we are just starting out, and my husband is a newly-minted software engineer. They change jobs often because it's project-based work, so I'm not sure a company 401k makes sense for him.

Thanks for any advice you can give.

[Gunny]

Google Index funds and you'll be provided all the info you need.  Basically index funds buy into which ever index the fund tracks.  For example, S&P 500 index fund holds shares of all the companies in the S&P index. There are stock indexes, bond indexes, REIT indexes, and on and on.  Because managing index funds cost fund companies so little, expenses ratios (cost to own) are very low making them even more attractive. Vanguard is the fund company of choice around here.  Vanguard has several really good low cost index fund options.  You can easily set up an IRA or a taxable investment account with Vanguard using their index funds.   

[Proud Foot]

Also, yes, I know traditionally people have a 401k, and Roth IRA, but we are just starting out, and my husband is a newly-minted software engineer. They change jobs often because it's project-based work, so I'm not sure a company 401k makes sense for him.

Thanks for any advice you can give.

If the company offers a 401k it almost always makes sense to use it.  Not only are you saving the taxes on your contributions but there is a possibility of a company match that vests immediately.  Also with the project based work, will he be changing employers after each project or will he continue with the same employer but working on a project for a different company?

[mrssavesalot]

Proudfoot, my husband changes companies very often. It's the nature of software engineering. Most of it is contract work, and when the company doesn't need him anymore, they get rid of him. He typically has 2 or 3 jobs a year. Kinda messed-up really, if you ask me.

[NoStacheOhio]

Hi all,

I'm new here. My husband and I are new to mustachianism, and just finally managed to get 10k saved in the bank. Since we are in our mid/late 30's, we're very eager to start building wealth for our future goals (a paid in cash urban house/condo and fully funded retirement).

Please don't hit me too hard, but exactly what are these index funds I keep hearing about, what sort of related fees do I need to plan for, and how much do I need to get started anyways.

Also, yes, I know traditionally people have a 401k, and Roth IRA, but we are just starting out, and my husband is a newly-minted software engineer. They change jobs often because it's project-based work, so I'm not sure a company 401k makes sense for him.

Thanks for any advice you can give.

Rolling over a 401k isn't too hard, and honestly it's sometimes you end up better off because an IRA may be more flexible.

[SeattleCPA]

Mike Piper, the CPA who blogs as the oblivious investor, has a relevant blog post you might find useful:

http://www.obliviousinvestor.com/8-sample-and-simple-portfolios/

Mike's a good writer and knows his stuff. This post isn't about indexing per se, but about using index funds to keep your investing simple, clean and profitable.

[dandarc]

Required reading before investing in stock:

http://jlcollinsnh.com/stock-series/

Or if you prefer books for this sort of thing, The Simple Path to Wealth is basically the same thing reformatted into a book.

[SeattleCPA]

If we're recommending books, can I recommend David Swensen's "Unconventional Success?"

It's more meaty, but wow, if you want to super-charge your investment knowledge, Swensen's book is the one to go with.

Swensen, BTW, runs the Yale endowment fund and has a multiple-decades-long investment record that is astonishingly good.

[YummyRaisins]

The thing about 401k employer matched contributions to keep in mind is that you may not receive those employer match funds until you are "vested". Sometimes that can take being employed with the company 2-3 years.

[MDM]

Proudfoot, my husband changes companies very often. It's the nature of software engineering. Most of it is contract work, and when the company doesn't need him anymore, they get rid of him. He typically has 2 or 3 jobs a year. Kinda messed-up really, if you ask me.

Does he receive W-2 or 1099 forms to document his pay?

[MustacheAndaHalf]

Think of "index" as beng like "sampling".  You want to eat a variety of food, so you sample different foods from different countries.  You don't eat every food, but you try to cover each aspect of eating.  You want some salty, some sweet, some from Mexico, some from Japan.  And this sampling is very much what an index fund does for company stock.

You've probably seen "S&P 500", which is a stock index.  S&P researches what goes into it, and then Vanguard (for example) borrows that recipe to make it's S&P 500 index fund.  For us consumers of index funds, we want to know what subtracts from our money.  The #1 problem is "expense ratio" or "annual expense ratio".  Every year, some bad funds eat up 1% of the money in the fund - silently.  Vanguard and Fidelity, however, have S&P 500 funds that eat up only 0.05% of that money.  So before these index funds even start the year, they typically start ~1% ahead of high cost funds.

One caveat: in general people who invest ignore the possibility that some people have 100% cash.  So if you have 100% in cash, including an emergency fund, even the "bad" 1% cost funds are going to do better than cash in the medium to long term.  In other words... START!  You could pick Vanguard and their "Total Stock Market Fund" because it captures all U.S. stocks.  Vanguard has low fees.  But if you don't take that suggestion, make sure you start rather than stay in 100% cash - because 100% cash is far worse than the difference between a 1% and 0.05% annual cost.

[pumpkinlantern]

Please don't hit me too hard, but exactly what are these index funds I keep hearing about, what sort of related fees do I need to plan for, and how much do I need to get started anyways.

There are lots of articles on this, so google-away as another poster suggested to get more info.

Here's a quick summary to start.

An "index" is basically something that tracks an entire segment of the stock market.  There are standard criteria that are used to put these stocks into the index and the percentage of these stocks.  The most common index you'll hear about is called the "S&P 500", which are the largest 500 publicly listed US companies.  The "S&P 500 index" are a collection of these stocks, weighted by the value of each stock (eg. a stock worth 2 billion will be 2x as large a portion of the index as a stock worth 1 billion).  There are other indexes that track other stocks including European, Australia, emerging markets.

An "index fund" is a fund that tracks an index.  So when you buy $10,000 of an S&P 500 index fund, you are buying some proportion of the 500 US stocks in the S&P 500 index.  Because they don't require active stock picking, they generally have low fees (check this before buying).  Because the general stock market goes up in the long-term, you will effectively be buying the general upward trend of the stock market if you buy and hold for a long period of time.  The S&P 500 has historically had a 10% annual return (6% after adjusting for inflation), although it fluctuates dramatically from year to year ("volatility").


In truth, an index fund is simply a very special mutual fund, although when people talk about "mutual funds" they are usually talking about funds that have a manager who actively picks stocks that they think will do well.  The problem with mutual funds is that the fees are much higher.  The managers don't always pick stocks that do well and even if they happen to pick better stocks, the fees are higher than the improvement in the returns.  On average, actively managed mutual funds do worse than index funds for this reason.  This is why many people, including many on this forum, advocate for holding index funds.

If you have a reasonable amount to invest (at least $10,000-$25,000), then you can also buy ETF's (exchange-traded funds), which can also track indexes, so as you are doing your reading, you can google that as well!

[mrssavesalot]

I'd like to thank you all for your comments and advice. It's much appreciated.

[financiallypossible]

Hi all,

I'm new here. My husband and I are new to mustachianism, and just finally managed to get 10k saved in the bank. Since we are in our mid/late 30's, we're very eager to start building wealth for our future goals (a paid in cash urban house/condo and fully funded retirement).

Please don't hit me too hard, but exactly what are these index funds I keep hearing about, what sort of related fees do I need to plan for, and how much do I need to get started anyways.

Also, yes, I know traditionally people have a 401k, and Roth IRA, but we are just starting out, and my husband is a newly-minted software engineer. They change jobs often because it's project-based work, so I'm not sure a company 401k makes sense for him.

Thanks for any advice you can give.

An index fund is typically a composite of many companies based on market weight (also called market capitalization). The larger the company's market capitalization, the greater its representation within the index (provided the index includes it at all).

For instance, an index fund that tracks US small caps wouldn't have names like AAPL or AMZN. However, an index fund with tracks US large caps or the S&P 500 would have those names.

Index funds are a great investing tool for investors as they are typically low cost (check that expense ratio!) and can provide diversification more easily than an investor doing their own research and buying dozens of individual stocks.

My complaint with index funds is that you get the good with the bad. You will get overpriced stocks and they will make up an oversized portion of the index precisely because of their overpriced nature increasing their market capitalization (number of outstanding shares * the price per share).

It's a bit like taking a trip to the grocery store and putting a little bit of everything into your cart without paying attention to the price of anything.

That said, I invest in index funds anyway in addition to purchasing individual stocks. There are many index funds out there which track different indexes, so you can pay attention to the price of the overall basket (such as the average P/E ratio for the stocks which make up the fund).