Index Funds – The Secret Tool For Wealth Building
Profits can be built in the short term, but wealth is built in the long term. And did you know? Individual stocks may go upwards or downwards in the long term but, there has been no single 15 year period in which the overall market has gone downwards! Meaning, there has not been a single 15 year period where the market returns have been negative.But you might ask me how this information is relevant to you or hold any importance in your investing journey. Well, enter – Index funds.
So what exactly do they mean?
An index fund is a type of mutual fund or exchange-traded fund (ETF) that holds all (or a representative sample) of the securities in a specific index, with a goal to match the performance of that benchmark as closely as possible. The S&P 500 is perhaps the most well-known index, but there are indexes—and index funds—for nearly every market and investment strategy you can think of. (source – Investopedia)
To elaborate further, it is a fund that invests in a basket of stocks that mimic or represent the entire market, e.g., S&P 500, FTSE Euro 100 Index.
The problem with traditional investing
Most of us would recall our parents saying they are saving for our future by keeping money aside in a fixed deposit or a fixed interest-bearing asset like a savings account because it gives consistent returns and is one of the safest modes of investing money. They may also have cited the reason that investing in stock markets is a risky task. Well, they are partially correct. If you think about the short term, their arguments do make sense. Equities are risky in the short term. But the keyword to remember here is short-term. Unless you have a specific expense coming up in 1 year, all your perception of risk about equities is unfounded.
Why Index funds –
Look at this example. While the S&P 500 fluctuates quite a bit in the short term, in the long run, it delivers pretty consistent results. Over time, the S&P has produced total returns of around 9%-10%. It means that if you invest $100 per week in an S&P 500 index fund like the Vanguard. Based on an annualized return of 9%, within 35 years, you have a chance of becoming a millionaire
|Period||$100 Weekly Investment Compounded at 9% Per Year|
(1 lakh is 1/10th of a million)
Sensex refers to India’s benchmark index. It represents 30 of the most extensive and most well-capitalized stocks listed on the Bombay stock exchange(BSE).
Data shows that the market returns over a long period have remained relatively stable.
All you need is some capital and lots of patience.
Sounds strange, doesn’t it?
Hear what Warren Buffett has to say about this –
Passively managed mutual funds outperform most actively managed ones over a period of time since it’s extremely difficult for a fund manager to deliver consistent returns year in year out. Since there are no fund managers, these passive funds charge significantly less than other MFs. You are trusting the collective judgment of the entire stock market. There’s no manager to pay!
Another way to invest in the entire market (index) is to invest in exchange-traded funds (ETFs) that track the stock exchanges. An exchange-traded fund (ETF) is a type of security that tracks an index, sector, commodity, or another asset but can be purchased or sold on a stock exchange the same as a regular stock.
By investing in ETFs, investors can instantly diversify their portfolios while getting exposure to foreign companies, spreading their investment across various companies. Since ETFs don’t have to be actively managed, they tend to have lower costs than other investments and have less risk than investing directly overseas.
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The Bottom Line
After taking all the following things into consideration, it is evident that for a person who doesn’t know much about investing but who wants to get a piece of the market action, a passively managed index fund is the best bet. There is a very high chance that he will do better than 90% of the other funds in the market.
One should be careful not to put all the eggs in one basket and should obviously diversify since index funds take time to manifest and might not be the ideal investment from a short to medium-term perspective.
Attention should be paid while selecting an index as they vary to a large extent in terms of companies and risk exposure. Compare the exit load of various funds and select one which is on the lower side. Also, pay attention to the expense ratio; it can be anywhere around 0.03% to 0.3%, not more than that.
A Few Examples Of Index Funds –
Vanguard 500 Index Fund (VFIAX)
Also known as the Vanguard S&P 500 Index fund, this is the one that started them all, giving investors exposure to 500 of the largest U.S. companies, which make up 75% of the U.S. stock market’s total value.
Minimum investment: $3,000. Expense ratio: 0.04%.
Vanguard Total Stock Market Index Fund (VTSAX)
Three-quarters of the U.S. stock market, not enough? This fund covers the entire U.S. equity market, including small-, mid-and large-cap growth and value stocks.
Minimum investment: $3,000. Expense ratio: 0.04%.
Vanguard Balanced Index Fund (VBIAX)
As the name suggests, this fund mixes its investments between stocks (roughly 60%) and bonds (about 40%) to balance growth through exposure to equities with stability through fixed-income investments.
Minimum investment: $3,000. Expense ratio: 0.07%.
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