Episode #65 – If Only I Understood Index Funds 20 Years Ago…

 

In this episode I dig into the various types of investments you can make in the stock market, and what they mean.

These lessons are not taught in public schools. Why not?

Tune in to learn from from my mistakes.

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Listen to the podcast here

 

If Only I Understood Index Funds 20 Years Ago…

In this episode, we’re going to be talking about investing in index funds. If you follow any of the finance content creators that are on Instagram or TikTok, other than me, a lot of them are heavily focused on investing in index funds, and for good reason. This is something that I wish that I had done back when I was 19 or 20 years old, and starting to earn some cash, becoming profitable with my business, but I didn’t because I didn’t understand it. I didn’t know how they worked. I didn’t get it.

I’d never forget my Economics Professor. I asked him about what he does in investing. How does he focus on what he invests in? Essentially, he told me that every single month, no matter what happens with the market, it goes up, it goes down, sideways, he doesn’t care. He buys the total market index. Instead of listening to the wise guy that understands finance and economics and how to invest, what did I do? I didn’t do that.

I went to a broker and gave him all my money. He invested it all into tech stocks that crashed and dropped in half. I made a couple of mistakes, and I’ve talked about this on my platform before, where I invested a huge lump sum. I put all of my cash in and didn’t keep any cash back for emergencies or for projected living expenses. As I graduated from college, I didn’t have any cash banked for that. When the market dropped, and it dropped hard and fast in 2000 when the Dot-com bubble burst, I had to sell a lot of these stocks or pretty much sold all of them to have the cash to then live off of.

I was not a great investor. I was a poor investor. I didn’t know what I was buying. I invested a huge lump sum more than I could afford, and then when the market dropped, I panicked and sold. I did everything wrong. I’m going to teach you how to do everything right when it comes to investing in the market, and a great play here is index funds. This is more of a fundamental baseline strategy. This is a long-term play.

Investing into index funds is not going to help you to retire young and retire early unless you do invest huge amounts every single month then it’s possible. Over a ten-year period, you could have accumulated an incredible nest egg, but more than likely, this is a 20-to-40-year type play, and it’s a good play. I’ll explain why.

Index Fund

What is an index fund? Essentially, you’re buying a tiny piece of all stocks in the market, depending on the fund, and I’m going to give you a couple of examples of funds that I like, that I’ve researched, recommended to me by other people that are hyper-focused into this particular investment strategy. An index fund is either a mutual fund or an exchange-traded fund that has one simple goal. They want to mirror the market or mirror a large portion of it.

There are some funds where you’re buying the entire market, pretty much all stocks that are publicly traded, enlisted on the stock market, and then you have others such as the S&P 500 or the Nasdaq-100, and you’re buying a large portion of the stock market, but you’re not buying all of it so in the S&P 500, you’re buying the 500 largest companies.

 

With the S&P 500, that’s more representative of the total stock market index or the total stock market because you’re buying in different sectors. Whereas the Nasdaq is tech-heavy. Most of the tech stocks are going to be listed on the Nasdaq. The Nasdaq generally is going to be a little bit more volatile. Tech stocks tend to run up faster, but they also tend to draw down quicker.

As we’ve seen the past couple of months, the Nasdaq has dropped almost 15% to 17%, whereas the S&P 500 has dropped around 9%. What this investing in an index fund is going to do is it gives you a more diverse portfolio than buying individual stocks. The most important takeaway for you to remember and dwell upon when you look at investing in an index fund is that you’re betting on the American economy. You’re betting on America to continue to grow over the long term.

You understand that there are going to be ups and downs in America. There are going to be times when the economy doesn’t grow and it retracts. When that happens, the index funds are going to retract along with them. If you’re confident that America’s going to continue to grow over the next decade, two decades, and more, which I certainly am, and based on the last 100 years, it’s a pretty good solid bet moving forward that a bet on America is a great thing.

Regardless of how you feel about what’s happening in the country politically, regardless of however you feel about different things that are going on that you may or may not like how they’re going down, it’s a smart move to put those feelings, and those emotions aside as an investor and strictly look at the American economy over the course of a long stretch of time.

I would say that over the long haul, it’s a good bet. If you buy into an index fund, you got to have a decade or more type of thinking process where you’re going to put the money in, let it do its thing, not check it daily, and not worry about it. Keep doing that over and over again and over a long period of time. It’s almost certain that you’re going to be a winner.

What is an index fund in terms of relation to an actively managed fund? I’m going to talk to you about the differences here because this is critical for you guys, in your wealth-building strategy to understand why an index fund is superior to an actively managed fund. The objective of an index fund is to generate a return that’s equal to the performance of the index, or the stocks in that index that it tracks.

Whereas an active fund attempts to outperform or beat the market. An active fund is going to have a purchase inside its portfolio. An active fund may add stocks that are outside that index, whereas an index fund has to hold the same stocks to the index that it tracks. Think of an index as a collection or a basket of companies or stocks that are tracked. The cost is the key difference here.

When you invest in index funds, you're betting on America and the American economy to grow over the long term. Share on X

While an index fund is going to be passively managed, index funds are managed essentially by a computer and an algorithm. That’s why it has much lower expenses than an active fund. Although it may not appear to be much in terms of savings, 0.5% or less is typically the ongoing fee for an index fund versus a mutual fund, which could have one to 2% even higher. Those fees over the course of time create an enormous drag or a reduction in the performance of an investment.

When I was looking at the difference between the two, if all things being equal, if you had 2 investors put the same amount into an index fund and 1 put the same amount of money repeatedly, over a course of, say 3 decades into a mutual fund, that extra 1% fee created several hundred thousand dollars indifference between the two performances between the returns and the profitability.

It’s a staggering amount. Most people that invest in mutual funds are not factoring in how much those fees are. It doesn’t seem much, 1%, 2%. When you look at that, you’re like, “That’s not much. How’s that going to make any difference? I’m paying that one, I’m paying that fee for somebody to professionally manage my money.” The bottom line is that 90% of all mutual funds do not beat or outperform the total market so you’re overpaying for underperformance.

I don’t think anybody that goes to buy anything wants to overpay for underperformance, whether it be any type of service or buying a product, or buying an investment. Who are index funds for? They’re for investors who want to create wealth over the long term with equities, with stocks, but they’re skeptical, and rightly so, of the role of fund managers and their fees.

Advantages Of Index Fund

What are the advantages of index funds? There are five main ones that I have. There are more than here but these are the most important ones. Number 1) It creates a diversified portfolio that is automatically done for you in one simple step. Essentially, all you do, you’re one simple step is to buy. When you buy the total index fund, automatically your money is spread out for you across the board of many different stocks and companies.

It reduces the volatility of buying individual stocks. You’re going to have a much more diversified portfolio. You’re not going to have quite the dramatic downswings, or you’re not going to have quite the dramatic upswings either. It has much lower fees than mutual funds or hedge funds, drastically lower than hedge funds.

There’s a famous bet with Warren Buffett. He challenged any hedge fund for a $1 million bet. Can you imagine that? You’re a $1 million bet. He challenged them that over a course of a decade, there was no hedge fund manager minus the fees that they charged that could outperform the market. There was one guy who took them on and he conceded after year seven. He said, “I can’t win. I concede.” he ended up funding a charity so the million dollars didn’t go to Buffett, but it went to the charity of Buffett’s choice but isn’t that interesting?

 

Only one hedge fund manager was even willing to take on that bet. You would think that they’d be so confident in their skills and in their abilities that they would jump on that back as easy money. The advantage, it’s extremely passive. The only decision that you need to make is how much to fund each month and if you set it up automatically, then you’ve only made that decision one time. Maybe periodically you review and look at increasing the amount that you’re funding. I don’t generally recommend decreasing the amount that you’re funding unless you are competent in the other place that you want to place those funds.

It’s a real sit-it-and-forget-it type of investment. 90% of professionals cannot beat the market. I want to keep stressing about that. Make sure I drive that point home to you guys over and over again, because it’s an important part of this. I feel the disadvantages to this are much lower than the overall advantages, but there is one primary disadvantage that you need to be aware of.

It’s so diversified that you have almost no chance of outsized gains. it’s almost impossible for the stock market to go up 10X within 1 year or 2 years, or generally speaking, unlikely to do that over even 1 decade or 2 decades. You’ve diversified yourself to the point where your returns are going to be much lower than if you were to pick individual stocks and make the right picks.

That’s one big disadvantage. A disadvantage to investing in the market is that they have short-term price drops that are normal in the stock market. As I alluded, over the last couple of months, we’ve seen a pretty significant sell-off. A 9% correction or an almost double-digit drop is certainly a significant drop in the stock market. In order to be able to overcome those types of drops, you must be continually investing over multiple years. You want to take advantage of dollar cost averaging.

The other thing that I didn’t even think about as a potential disadvantage is that there are tracking errors. Even though index funds aim to mirror the market, the returns are generally, for some of these, marginally lower. Marginally means slightly lower, but this does happen more than the index that they track, and that’s due to multiple factors. One of those is cash sitting on the books. That’s not invested in the market. If it’s a good fund, the cash is not sitting idle on the sidelines but this is part of the slight drag that you’re going to see when you do invest in an index fund.

Recommended Index Funds

What are the recommended funds? I have two. I want to keep this simple for you. Too many options create paralysis by analysis as they say. The two funds that I recommend are the Vanguard Total Stock Market Fund in which the symbol is VTSAX. The symbol is important because when you look up a stock in your brokerage account, you’re going to look for it or search for it by the symbol. It’s usually a shortened version of letters that signifies or represents that particular stock for that company.

This is a diversified fund, and it’s buying almost all of the stocks that are publicly traded in the stock market and the expense ratio show is low. It’s only 0.04%. You’re not going to get too much lower than that as far as an expense ratio goes. There are some that potentially go a little bit lower, but negligible. To give you an idea, not all the stocks in an index fund are weighted equally. There are going to be some stocks that are going to be a higher percentage of the total holdings that are inside of that basket of stocks.

It's a smart move to put your emotions aside when investing. Share on X

For example, in the total stock market fund, the number one position is Microsoft. That’s a great company to own, be proud to own that company. That’s a solid and stable company that produces cash like thousands of ATM machines. The percentage is 5.3%. Out of the total, say 100% of the investment, 5% of that fund is invested into Microsoft. That leaves a lot of these other stocks to have probably less than 1%, 0.5%, or even less than that.

Amazon is number 2 at 3.22%. Tesla is number 3 at 1.96%, and Google is number 4 at 1.83%. Right there alone, you have over 10% of the total Vanguard Fund invested into those four companies and those are great companies. Those are companies that we would all be proud to own and love to own. We all use their products and services more than likely for all four of those.

I can look at these and say, “I have Microsoft products. I’ve used them many times over the years. I have Amazon arriving at my doorstep every single day. I own a Tesla. I love Tesla. I think that we’re going to see more and more products from Tesla that you’re going to be using in your everyday life as well and then, all my searches are on Google.” I utilize these top four almost on a daily basis. The minimum investment to get started in this fund is $3,000. You need that in order to essentially get started and then after that point, once you’ve made the minimum investment, you can invest in smaller increments.

The second fund that I recommend is VFIAX. It’s the S&P 500 and you guessed it. This is a basket of 500 stocks. This is typically the top 500 stocks in the market-by-market cap so this also has the same low expense ratio as the Vanguard Fund. It’s only 0.04%. The top four stocks in this are a little bit different. Apple is number 1 with 5%, almost 6%. Microsoft is the 2nd with almost 6%, 5.62%. Amazon is 3rd at 4% of Facebook is 4th at 2.29%. Almost 16%, 17% of the total S&P 500 VFIAX fund is invested into those four stocks.

Apple is a company that I’d be proud to own. I use Apple products every single day. I have an iMac. I have an iPhone. I have an iPad. I have multiple iPhones in our house. We have six. I have tons of Apple products. Same with Microsoft, Amazon, and then Facebook, we utilize that. We’re on it quite every day. I run ads through Facebook, although as a human, I don’t like what Facebook does in terms of censoring what people post.

I’ve seen a lot of my friends, people that I know that have posts that have been taken down or banned or that they’ve been in Facebook jail for a week or even longer for things that they’ve said. I don’t like or agree with censoring free speech. If there are any hate or derogatory type comments, I would like those to be censored, but other than that, I do not feel that our speech should be censored. I need to separate those emotions right from my desire to grow my portfolio as an investor. Facebook is certainly a solid company that I’d be semi-proud to own as I’ve previously described why, and the minimum investment is $3,000 for this fund as well.

Which one do I like between the two? I don’t have a strong opinion. As you can see, you’re more diversified in the total stock market fund because you have the entire market. Your returns are going to be probably a little bit lower, although the downside is going to be a bit lower as well. You’re going to have a little bit less volatility. I don’t think it’s going to be by a lot. You have 500 stocks versus over 4,000 stocks. The 500 that are in the S&P 500, you’re going to have a little bit more upside potential, but a little bit more downside potential as well but again, I don’t think that’s a significant difference. It depends on your personal desire to own the entire market or the top 500 stocks that are in the market.

 

Getting Started With Index Fund

How do you get started? simple. You open up an online brokerage account if you don’t already have one. A lot of you probably have one, a TD Ameritrade account, Charles Schwab, and a Robinhood, which I don’t at all. That’s probably a separate episode but I like Fidelity. I did research and Fidelity came up at the top I’ve been happy with the simplicity and all the features that are available inside of this brokerage account.

Go to Fidelity.com and click on Open an Account. It’s simple to set up an account. Once you’ve opened your account, you need to connect your bank account to your brokerage account so you’ll enter all your checking accounts and your bank information there. It’s very simple to do. That connection allows you to transfer funds from your checking account into your Fidelity brokerage account.

Step three is that once you have that connected, it usually takes a couple of days because they need to verify your checking account and there’s typically a couple of business days that that takes. Once that’s verified and connected, then you’ll transfer the cash from your checking account that you want to invest into the market to your brokerage account.

4 Reasons To Auto Invest

Step four is you’re going to purchase either the suggested index funds by clicking trade and then entering the symbol. Again, the symbols are VTSAX or VFIAX. I recommend step five to set it up automatically. There are a lot of reasons why, but I’m going to cover the top four reasons that you want to auto-invest. Number one is the most important, which is called dollar cost averaging. Instead of investing a large lump sum amount all at once, you’re going to invest smaller amounts consistently over a longer period of time.

This dollar cost averaging helps you take advantage of market drops so then when the market drops, you’re able to buy shares at these lower prices and it also helps smooth out the volatility that you’d have the big up and down price swings in your account. It’s going to help you to smooth out that volatility by spreading out your picks over the course of time.

The second reason to auto-invest is less stress. You don’t have to think about it. You don’t have decision fatigue, that tiredness that you get when you have too many decisions that you need to make too often. It also takes the stress out of any decision-making in terms of, “Emotionally, do I feel I want to do this? Do I not? Did I forget to do it? Oh my God, I forgot. The market just dropped. Should I should I invest? I don’t think I should. The market’s taking.” It takes all that stress out of your life and it automates the decision-making process. Studies have shown that investors are more successful when they do it this way.

The third reason is out of sight, out of mind. Your funds are transferred automatically from your checking account each month. Again, you don’t think about it. The money’s thrown into your brokerage account. It automatically purchases those index funds and it again takes that decision process out of your hands.

Automatic investing takes out the stress from your life. Studies have shown investors are more successful when they do it this way. Share on X

The fourth thing is the lack of discipline that we all have. If we were left to our own devices where every single month on the same date or even the same week that we would need to remember and then go log in and then purchase the shares, transfer the money, and do all the manual steps that it would take, we’re probably not going to do it.

We’re going to miss some months and we could be missing some great buying opportunities when the market drops. I told the story on this platform, but I’ll remind you about it as well. When I went to do my charitable giving, we were manually writing checks and that dates me a little bit. You’re like, “What a check? I only know Venmo or PayPal.” I’d be manually writing checks and putting them in the offering bucket and I was inconsistent. I lacked the discipline to be able to remember to write the check each month and do it. I’ll sometimes lack discipline emotionally. I didn’t want to give that month. Maybe my business wasn’t doing as well. Something negative was going on. I wasn’t feeling in a charitable mood.

Setting Up Auto Investing

Once I automated that in that charitable giving, I have yet to miss a month going on a few years. It entirely takes out the lack of discipline that you may have so what are the steps to set up automatic investing? Number 1) I’ve mentioned you must already put in the minimum $3,000. Number 2) Once you do that, you’re going to log into your Fidelity account. You already have to have the $3,000 minimum investment purchased in either of these two funds.

Once that’s done, then you’ll log into your Fidelity account, you’ll click on Transfers, which is under Accounts and Trade. You’ll click on Manage Automatic Investments, and then you’ll see a question, “Where do you want to invest the money from?” You’ll select External Bank Account right there and then you set the date. You want the automatic withdrawal from your bank account. You enter the symbol for the index fund when you’re prompted, click confirm, and presto, your money’s going to be debited from your checking account on that same day every month automatically and inside your brokerage account.

It is going to automatically purchase those funds once the funds are cleared into your brokerage account. Presto, boom, you’re now a disciplined investor because you made one decision for the next several years. Again, I would strongly urge you to take a percentage of your total investible dollars and put it into the total stock Market index fund.

I don’t recommend personally doing all of your investment dollars into an index fund as you all are clear by now if you’ve watched my videos and all of the things that are on my platform. I strongly recommend asset allocation but I do believe as far as in stock market play, that having some of your money in a total stock market index and then having some of your money in individual stocks, that research shows that they could potentially go up 10X, 20X, or more.

I want to have exposure to some of those great trends, those great companies that are early stage, that could make some incredible strides and growth over the next decade. I don’t want you guys putting all your eggs in one basket even inside the stock market. We want to make sure that we’ve set ourselves up to have great stability and fundamentals with an index fund, and then take some swings for the fences with some well-researched early-stage, early high-growth type of opportunities that can make some incredible strides like some of the ones that I’ve already outlined.

I hope this helps. Let’s get going. This is easy for you guys to do and it’s easy for you not to do but right now with the market having dropped, this is a perfect time to buy in. Will the market drop some more? I have no idea. Nobody knows. Very possibly could. If that happens, put it in and forget about it. Don’t let the swings of the market set yourself up for doing something dumb like stop investing or waiting for the market to drop even more.

That’s never going to work because it’s incredibly difficult to be able to time the market and time the dips. Keep buying, keep investing, and over the long haul, you’re going to be happy that you did. I wish that I had done this starting at age 19. I’d be incredibly wealthier than I am, but at least you guys can learn from me and do what I wish I would have done. You guys can do it right now, so take action. Let’s go.

 

Important Links

• Fidelity.com