Effortless Investing for Beginners: Index Funds Are Your Ally

I always had this feeling that I was missing out on this big world of investing. It seemed like everyone else was doing it, but I knew nothing about it. All I knew, vaguely, was that investing in stocks was a good financial move. 

So when I was offered a 401k at my first full-time job, did I learn about investing to make an informed decision about my portfolio like a responsible adult? 

Nope.

I simply copied the portfolio of one of my coworkers, a terrible decision because I shouldn’t have been so lazy and indifferent (not because my coworker was bad at investing). Later on, another lazy decision would cost me thousands of dollars (a story for another day), teaching me the importance of understanding where your money goes.

Several years down the line, during the boom of stock trading apps, I decided to finally develop an understanding of this nebulous world. This time I asked a coworker, not for specific stocks to invest in, but for recommendations on where I could learn how to invest. He pointed me to a book called The Little Book of Common Sense Investing: The Only Way to Guarantee Your Fair Share of Stock Market Returns by John C. Bogle, founder of Vanguard, one of the top investment management companies in the world.

Reading this book, I discovered that for the vast majority of people, investing in passive index funds is the key to success. Here are three of my favorite reasons why:

• It keeps costs down
• It reduces risk
• It saves time 

The alternative to passive index funds are actively managed mutual funds overseen by portfolio managers who actively trade securities with the goal of outperforming the market and achieving higher returns. As enticing as this may sound, there is a wide body of evidence that shows how index funds outpeform the majority of actively managed funds, especially over the long term.

Ready to build a portfolio that gives you confidence and peace of mind? Read on as I unpack the reasons to go with index funds.

Keep your costs down

An actively managed mutual fund is subject to a higher rate of additional costs associated with portfolio management, administrative expenses, operational costs, marketing, and other fees. These costs typically range from 1-2%. In contrast, a solid index fund comes with significantly lower additional costs—commonly much lower than 0.5%. 

Noting the difference of such small percentages seems like splitting hairs, but in the long run the higher costs eat up much more of your potential accumulation and can easily compound to thousands and thousands of dollars.

Take the following scenario where we assume both passive and actively managed funds perform the same over the span of 25 years (though historically actively managed funds underperformed their benchmark indexes long term):

• An initial investment of $10,000
• An average annual rate of return of 7%
• A monthly contribution of $500

With an index fund that cuts into your average annual rate of return by 0.5% (giving you 6.5%), in 25 years your investment will grow to $401,603.06:

Conversely an actively managed fund that cuts into your average annual rate of return by 1.5% (giving you 5.5%), your investment will grow to $345,049.45:

The difference comes out to $56,553.61 over 25 years. All of that is money that goes directly to the fees and costs of the actively managed fund.

It’s also worth pointing out that higher turnover rates in actively managed funds lead to higher taxes due to substantial short-term capital gains, taxed at much higher rates than long-term gains.

In investing, you get what you don't pay for.

John Bogle

Reduce your risk

While there will always be risk of the stock market itself, holding index funds eliminates the risks of picking individual stocks, emphasizing certain market sectors, and portfolio manager selection by diversifying across a broad range of securities. Since index funds aim to match the market, it will essentially perform no better or worse. 

Actively managed funds, on the other hand, can suffer from higher turnover rates, concentration risk, attempts at market timing, and performance variability, among other things. In the "expectations market" prices are not set by real factors such as sales, margins, or profits but by expectations of investors. It is largely at the mercy of speculation, where investors and managers are guessing what other investors will expect and how they will react to each new bit of information. Inconceivable!

The bottom line is that if the portfolio manager underperforms, you are on the hook for the loss and all the above-mentioned costs that come with active management. You put up 100% of the money and assume 100% of the risk. It stands to reason that you want to minimize the risks as much as you can, and it's much harder to do with these mutual funds.

Save your time

Investing the majority of your capital in index funds as opposed to actively managed funds (or even the trading of individual stocks) eliminates the need for extensive research and analysis of the ever fluctuating market. 

All you need to do is find an index fund that covers the whole market, make sure the expense ratio is low (the one I chose has 0.015%), contribute regularly, and hold it forever. As you get older, you just need to adjust the asset allocation of your portfolio between index funds and bonds. For bonds, look at high-quality and intermediate-term (or short-term) government bonds and investment-grade corporate bonds.

Bogle's simple guideline is to increase the percentage of bonds to match your age:

• 70% in stocks and 30% in bonds at age 30
• 50% in stocks and 50% in bonds at age 50
• 30% in stocks and 70% in bonds at age 70

As you tinker with the allocation, keep in mind your risk tolerance, financial goals, and market conditions.

And that's it. It takes a little front-end effort and minimal maintenance over time. The time you save from not having to keep up with stocks on a regular basis can be used to attend to other important areas of life.

Still not convinced?

Allow me to introduce you to Warren Buffett, widely considered one of the greatest investors in history. While he achieved his success with actively managed strategies, he endorses index funds for the average person:

1. In a 2013 letter to Berkshire Hathaway shareholders, Buffett revealed that he instructed the trustee for his wife's inheritance to allocate 90% of her money to a low-cost S&P 500 index fund and the rest in short-term government bonds.
2. In his 2016 letter to shareholders, Buffett said, “When trillions of dollars are managed by Wall Streeters charging high fees, it will usually be the managers who reap outsized profits, not the clients. Both large and small investors should stick with low-cost index funds.”
3. At a Berkshire meeting in 2017, Buffett praised Bogle, the index fund pioneer, estimating that he “at a minimum, has saved — left in the pockets of investors, without hurting them overall in terms of performance at all — gross performance — he’s put tens and tens and tens of billions into their pockets.”

To be fair, actively managed funds do have certain advantages over passive funds that I won't go into here. And there can even be a place for careful and strategic individual stock trading. That said, if you want to keep costs down, reduce risks, and save time, keep active trading to a minimum.

I wish I had known about all of this earlier in my life, but I hope my learning experience can help steer you in the right direction so you, too, can become a confident investor.

If you want to ensure you’re not missing out on the true benefits of investing, consider the humble index fund.

Want to learn more? Get John Bogle's The Little Book of Common Sense Investing: The Only Way to Guarantee Your Fair Share of Stock Market Returns.