If you’re overwhelmed with the entire idea of investing, I understand. I was too when I first started investing the past year. I really didn’t know where to start, so I started googling. Soon I was lost in the interwebs and landed on a page talking about low-cost index funds.
This sparked something in me – especially the low-cost part! So I researched the low-cost index funds. What did I find? That low-cost index funds are generally performing like the overage market, but you pay fewer fees than any other way of trading. This means that more of the profit is left for you. Don’t we all want that?
One of the most successful investors in history, Warren Buffet, has an opinion about index funds. As I’ve learned many lessons from Warren Buffett, I tend to listen to him. 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 most return on investment.
So let’s begin by talking about some background about mutual funds & index funds, why you should also start investing in low-cost index funds, and where you should 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 run funds, they aim to make above-average market returns. With above-average, I mean more than the market is making. For example, a US mutual fund would want to outperform the US stock market.
Spoiler alert: the majority of mutual funds don’t outperform the average market!
Why would an actively managed fund underperform? Well, one of many reasons is the fees. If your mutual fund is outperforming the market by 1%, and you have to pay 2% in managing fees, that obviously means that your return has gone to the fund.
Also, Standard and Poors did a study among a large amount of actively managed funds. They found that over a 5-year period, less than 14% of all actively managed funds outperformed the market. Wait for it, over a 15-year period, less than 6% of all actively managed funds outperformed the market.
This means that over a short-term horizon, active fund managers might be able to outperform the market. BUT, if you’re investing for the long term, outperforming the market becomes harder and harder.
Index Funds 101
We’ve talked about mutual funds, now let’s get to the good stuff! Index funds are passively managed funds. Their goal is to match the performance of an index.
You can have index funds that track the performance of:
- The entire US stock market
- A certain sector of the US stock market (for example oil)
- The entire world stock market
- The gold price
- Anything you can think of, they will probably have an index fund for that!
This means that you get a well-balanced selection of stocks across multiple companies or countries, while not having to buy every stock individually. You can diversify your holding across thousands of companies, sectors, or countries in one go!
It is really simple to create and manage an index fund. For any given index, you can find which companies or governments, or commodities are included. The index fund just buys all of the stocks that are included in the given index, that’s why the costs are so much lower.
Like we have discussed before in my Ultimate Guide to Financial Independence and Retire Early, the average return of the stock market earns around 9% annual return. In addition, the average mutual fund costs around 1.5% in investment costs. These are mutual fund fees and brokerage commissions.
BUT, many index funds only costs around 0.5% or even less! This means that you add an extra 1% return every year to your investment portfolio just like that!
You Mean I Should NOT Try To Outperform The Market?
I understand that it’s very counter-intuitive to think that when you are not even trying to outperform the market, you can actually come out above average. Your extra return doesn’t come from actual more profit on your index fund, but you put 1% in your pocket because of lower costs.
So, why wouldn’t you just invest in an actively managed fund that does outperform the market? Well, because it’s very hard to predict ahead of time. Both for the fund managers and for you. Because the fund manager can’t predict what the individual stocks are going to do, as much as they try they are not always right. Same for you, it’s difficult to predict ahead of time which funds are going to outperform the market.
Low-Cost Index Funds
Before you invest in an index fund, I want you to keep something very important in mind; not all index funds are low-cost. While there are some index funds that 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 take-home profit as big as possible. For me personally, paying 1.5% or more annually to just maintain my portfolio is a no-no. I believe in low-cost index funds, especially if you want to invest in the long term. You have the desire to become financially independent, save for retirement, or get out of debt. This is going to happen a lot faster when you invest in low-cost index funds!
More of the profit goes to your wallet when you are paying lower fees. This is the #1 reason why you should start investing in low-cost index funds
How To Pick Low-Cost Index Funds
When you are investing in low-cost index funds, keep in mind that you should look for 3 things:
- Low fees of below 0.3% (otherwise the low-cost part would be gone)
- Transparency, where you should be able to see in which stocks/bonds is invested
- Diversified across diverse countries/companies
After that, decide your desired exposure; where do you want to invest? You could go for only US stocks, only large companies, etc. Depending on what your goals are with investing, you are picking your exposure.
For me, I love to have the basis of my investments to be the Vanguard All-World ETF, which covers over 3000 stocks in 50 countries. In this way, the basis of my portfolio is steady, so that I already have a portfolio in many different economies and markets.
In Short: How Do I Start Investing?
When you want to start investing, know that you don’t need to pick individual stocks or invest in mutual funds.
- Actively managed (mutual) funds only outperform the market in 6% over a 15-year period. When they’re taking 1-2% of your profit, not much benefit is left.
- You take more risk when you’re investing in a couple of individual stocks, where you have very little diversification. If one stock goes bankrupt, 10-20% of your portfolio could be gone. Think about whether that’s a risk you’re willing to take.
Passively managed funds, or low-cost index funds, only take 0.2-0.3% of your profits. They track a certain index, making sure you get the average stock market returns. Plus diversification is no issue, you can get a LOT of stocks in one single low-cost index fund.
Popular index funds include VTSAX, VBMFX, VIG, FSMAX, VWRL, and many many more. This is no investment advice, please do your own research before investing in any of these funds.
How can I start investing? Check out these resources:
- Vanguard – One of the biggest investment companies and a great place to buy your index funds.
- DEGIRO – A low-cost European broker that I’m personally using. Read my full DEGIRO Review here.
- M1Finance – This is a US-based company that allows you to build your own stock portfolio, completely for free. No fees involved! Read the full M1 Finance review here.
- Acorns – Helps you to invest your spare change and start small with investing.
Are you (planning to) invest in low-cost index funds?