Investing is a somewhat simple idea, with numerous complicating factors. At the basic level, when you invest you own a part of a company. For owning that part, or share, of the company you will have an interest in how well the company does. If the company does well, it may pay a dividend (share of profits) for each share you own or your share might simply become more valuable as the company does. If the company does poorly, it may stop paying a dividend or your share may lose value.
Investing can be a great way to help grow your wealth over time. There are many ways to invest your money, but the one method that tends to work best for an average investor (that’s us) is investing in index funds.
Index funds are not an exciting way to earn money. They do, however, take a lot of the guess work out of investing. Index funds are types of mutual funds that attempt to track a market index. A common index fund is VTSAX from Vanguard. By putting money in this fund, or similar funds, you own a partial share of almost every publicly traded company in the United States. Since most companies and their stocks tend to do well over the long term, you have thus invested in all of the winners. Since more stocks usually win than lose, you win overall.
Managed Funds vs Index Funds
Another option, of course, is to invest in a managed mutual fund. This is where people like you or me have a manager invest our money for us. Mutual fund managers earn their living by trying to pick out which businesses, and thus which stocks, are going to perform the best. When these managers choose a stock, they are making an educated guess. Occasionally, one of these managers is good enough at this that they do very well for a while and make their investors, and themselves, a lot of money. However, most of the time they do not do well.
If you look at data like this you can see just how often their choices are not the best. That data tells you that over that 15 year period those managers’ choices made less money than the stock market overall. This is where index funds come in. If you invest in a total stock market index fund, such as those offered through Vanguard or Fidelity, then you will beat the managers almost 19 out of 20 times. Only those people who pick the correct manager, which is only 1 in 20 managers, can hope to beat an index fund.
On top of this, there are fees to consider. One of these is the expense ratio of the fund, which is an annual fee charged to you for having your money invested in the fund. You can think of it as the company charging for the convenience of investing in their fund and to keep track of your investments for you. With index funds, these fees are very low; VTSAX is currently at 0.04%. This basically means if the stock market goes up 12% this year, then you get 11.96% of that value and you pay Vanguard with the rest. With a managed fund, the fees are higher. Managed fund expense ratios are typically 0.50% or more. This doesn’t sound like a lot of money, but when you consider that managed funds typically do worse than index funds anyway it doesn’t make much sense for the average investor.
If you were to invest $1,000 into each of those two funds for 10 years with a 10% return, then you would be $120 ahead with the index fund. That assumes the managed fund even keeps up with the 10% the stock market returns. We just saw the data that it often doesn’t happen.
Take a look at this calculator from Vanguard if you want to compare expense ratios and fees in more detail.
Index Funds are easier
There are, of course, other ways to invest money. Some employees will have access to buy their company stock at a discounted price. Someone else might want to risk options trading. Still another person might think they know a company is close to a big breakthrough so they invest in that individual stock. All investing carries a risk of losing the money, though. By investing in index funds, you can minimize some of those risks. With an index fund you can invest in it and know you are doing better than the average investor.