Index Funds for Beginners

From the time I started learning about financial independence, I knew I wanted to help others learn and feel empowered to achieve their goals.   I recently got a question from a 30 year-old reader named Tanner who asked my opinion on his portfolio in their brokerage account. Tanner has been working with a financial adviser for a while and wanted to make sure he and his wife were doing the right thing for their growing family. I love questions like these, and my introductory response to index funds for beginners is below.  Have a look and let me know in the comments if you think index funds could be a good option for you or someone you know.

Dear Tanner, 

With the portfolio’s goal of growth over the long term to support you and your wife’s early retirement in your mid to late 40’s, I think you should consider index funds to simplify your portfolio.  Index funds are a great way to diversify your portfolio, pay low fees and still get good returns. Broad based index funds (for example, VTSAX that follows the entire US stock market or VFIAX which follows the S&P 500) are great for beginners and can be a key part of your investment portfolio for a few reasons.  

1. Diversification 
2. Low fees
3. Low turn over 
4. Returns
5. Self management, if you choose

I did a quick analysis on the funds in the portfolio so we could compare current funds and index funds (highlighted in yellow).  

Index Funds are Diversified by Design

First, what are index funds and why are they good for beginners or anyone for that matter?  Index funds are passively managed mutual funds which follow a market index such as the entire U.S. equity market, including small-, mid-, and large-cap growth and value stocks (like VTSAX), or the S&P 500 like VFIAX. VFIAX tracks 500 of the largest U.S. companies, which span many different industries and account for about three-fourths of the U.S. stock market’s value. Likewise, there are also bond index funds (like VBLAX), and all different kinds of international indexes, as well. Index funds are already diverse by definition which eliminates the need for numerous mutual funds in your portfolio. 

Side note, I’m referring to Vanguard mutual funds today, however other large brokerage firms also have great broad based index funds which are just as good. There is no need to purchase VTSAX if your accounts are at Fidelity, TD Ameritrade or another firm. Simply find Fidelity’s broad based index fund, for example FSTVX, and invest in that. The key here is to find broad based index funds.

Index Funds Have Low Fees

Fees are something to keep an eye on, starting with the expense ratio. The expense ratio is the cost of owning the fund year after year. With passively managed funds, like index funds, there is no fund manager involved. Index funds are set up to follow the index they are pegged to.  Actively managed funds, like JBGAX on row 2 of the spreadsheet, require you to pay 1.14% of your holding annually just to continue to own the funds regardless of how it performs.

With an index fund where you are paying 0.04% or even lower in some cases. I’ve seen 0.0% starting in 2019. Now this may not sound like a lot, but if you invest $100K in a fund with a 0.04% expense ratio, you will pay $40 per year. Contrast that with a fund with 1.14% expense ratio and you’ll pay $1140, like for JBGAX, just to own the fund. Every year!

Load Fees

The other fee to look for is load fees. There were 2 funds with load fees on your list. See rows 2 & 3.  You should find out if these are front or back loaded fees. This means you pay that percentage when you purchased the fund (front load) or you will pay that percentage when you sell the fund (back load). 

Financial Adviser Fees

Finally, you need to factor in the fees you are paying to your financial adviser every year. I’m assuming she is taking an annual fee based on assets under management – usually around 0.5% – 1% depending on the total value of the portfolio she is managing for you. You can ask her for the amount. This may not sound like much. But the key is to consider that fee plus the other two noted above. Compound these annually over the long term, 30+ years, and it will add up considerably.  Given fees paid, you should feel comfortable asking questions, and having your adviser explain ANYTHING she is recommending. Even, if it takes a few times to makes sense to you. 

Index Funds Have Low Turn Over

Index funds have lower turnover than actively managed funds. For example, see UMBMX on row 6 with 106% annual turn over vs VTSAX with 3%.  Turnover measures the percentage of a mutual funds holdings that are replaced in a single year. Assuming the fund manager sells stocks within the fund for more than they were purchased for, you will pay capital gains at tax time. And, you’ll pay taxes on this amount even if you are just holding the mutual fund and not selling anything.

Index Fund Returns

With index funds, you can expect to do as well as and no worse than the index.  If you look at how the S&P 500 has performed over the long term that’s a 9% gain on average which is great. But keep in mind, that’s an average over the long term. Some years it will be more and others less.  With actively managed funds, you have to be comfortable with the fund manager’s ability to grow the funds long term. It’s a small number of fund managers that can beat the S&P 500. (see this article).  Remember you are looking for investments over the long term – 25-30+ years. So even if you pick one of the 15% of funds that beat the market, you have to be able to keep picking that top 15% of funds which beat the market. Not easy to do even for experts.

Warren Buffet, CEO of Berkshire Hathaway and considered one of those experts, instructed his estate upon his passing to be invested 90% in S&P 500 index funds.  Here’s a link to an article and the actual letter to the Berkshire shareholders.  I think this is a good testament to index funds.

Self Management, If You Choose

With index funds you can greatly simplify your portfolio and strategy with an equity index fund like I mentioned above (VTSAX or VFIAX) and a broad-based bond index fund (VBLAX).   And, right now when you are working to accumulate assets you could even get away with one equity index fund depending on your tolerance for volatility (the ups and downs of the stock market). If you sleep better with less volatility in your portfolio, add a bond index fund.

If you are okay with the volatility since you know you won’t be needing the cash in the portfolio for a while, then keep things simple with one broad market equity index funds.  With index funds, you can manage your portfolio yourself, but you don’t have to. If you like using the financial adviser, you can always see if she’ll review your portfolio and plans on a regular basis as a fee for service.

The Bottom Line on Index Funds for Beginners

Mr BA and I are index fund investors. We look for index funds that are broad based, and have low expense ratios. We research up front and then set up automatic investments monthly.

In 2018, we came across the ChooseFI podcast in the summer and started researching. We listened to lots of podcasts, read lots of books, and kept learning. We simplified investments, rolled over old 401k accounts, pensions, and retirement accounts wherever we could to make management easier.

There’s a great blog by JL Collins that goes into excellent detail on index fund investing (the stock series). You should check it out.  Thanks for asking this question and best of luck to you on your path to early retirement.  

Let me know your thoughts in the comments below. Did I miss a key pro or con of index funds for beginners or seasoned investors? Let me know below.