Save for Retirement With Low-Cost Index Funds
Investing your money in the stock market doesn’t have to be difficult or stressful and you certainly don’t have to spend dozens of hours researching to succeed in the long term.
In fact, I would argue that the most effective long term wealth building strategy for the stock market also happens to be the most simple.
Our investing opinion is this: Buy an ultra-low-cost diversified index fund and continue to purchase new shares automatically on a set time schedule.
We love the Total US Stock Market Index Fund (VTSAX) or S&P 500 Index Fund from Vanguard, but there are comparable funds at other discount brokers that accomplish the same goals.
Don’t check how the market is doing, don’t get skittish and sell when the market drops, just keep pumping money in there week after week (Vanguard lets you set up an automatic investment on a weekly, bi-weekly or monthly basis, so whatever best fits your schedule).
You’re going to wake up one day as an extraordinarily rich person and you’ll have experienced much less stress along the way than nearly every other investor!
Related: Vanguard Vs. Fidelity--Which Company Is The Best Choice For You
How Does Warren Feel About Investing In Low-Cost Index Funds?
Don’t believe us? Here is Warren Buffett--the greatest investor the world has ever known--from his 2013 Berkshire Hathaway Shareholder Letter:
“The goal of the non-professional should not be to pick winners--neither he nor his “helpers” can do that--but should rather be to own a cross-section of businesses that in aggregate are bound to do well. A low-cost S&P 500 index fund will achieve this goal.”
“My money, I should add, is where my mouth is: What I advise here is essentially identical to certain instructions I’ve laid out in my will…My advice to the trustee could not be more simple: Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund. (I suggest Vanguard’s.) I believe the trust’s long-term results from this policy will be superior to those attained by most investors who employ high-fee managers.”
If that advice is good enough for Warren Buffett’s wife and children and their billions of dollars, you can bet it’s solid for your family too!
Our favorite resource to learn more about low-cost index fund investing is the Stock Series at JLCollinsNH.com. This has become the resource for the financial independence community and it is essential reading.
Related: How To Prepare For Drawdown During Early Retirement
What Is An Index Fund?
Investopedia defines an index fund as:
“An index fund is a type of mutual fund with a portfolio constructed to match or track the components of a market index, such as the Standard & Poor’s 500 Index (S&P 500). An index mutual fund is said to provide broad market exposure, low operating expenses and low portfolio turnover.”
In the case of the S&P 500, you’re buying a tiny piece of all 500 companies in the S&P 500 index. So many people miss this fundamental point: You are not buying a piece of paper when you buy a stock or mutual fund, you are buying an ownership percentage of an actual company!
So instead of short-term trading and getting lucky on stock price fluctuations, we are going for long-term wealth.
We are trying to build by buying a piece of either the 500 biggest publicly traded companies in the US (S&P 500 Index) or essentially every publicly traded company in the US when you buy a Total Stock Market Index Fund (at publication of this article, the Vanguard Total Stock Market Index Fund has nearly 3,600 companies in the index).
What Is Considered A Low-Cost Index Fund?
Index funds are passively managed, which simply means they don't have to pay a bunch of mutual fund managers and analysts to determine which stocks to include in the funds. This leads to less overhead and makes index funds, by their very nature, nearly always "low-cost" in comparison to actively managed mutual funds.
- The average mutual fund expense ratio will land somewhere between .5% - 1% (with many costing even more).
- The average index fund expense ratio is under .2%.
But while nearly all index funds will have relatively low expense ratios, certain index funds take things to another level. Most of the discount brokers offer index funds with expense ratios at .05% or below.
And at the end of 2018, Fidelity became the first broker to offer index funds with literally 0% expense ratios.
https://www.youtube.com/watch?v=ryUDIvaMNjs
Related: When 2% Costs Everything: How Investment Fees Cost You Your Freedom
The Impact of Fees On Your Investment
Over the long-term, almost no investor can outperform the market (and don’t get us started on timing the market, which is even harder). If you take that as a given, then the fees are the single most important factor in building your wealth.
Here’s a visual representation of the impact of fees on your investment:
Scenario 1: Low-Cost Index Fund all the way
We’re assuming someone starts with $100,000 and plans to invest for 40 years while adding $0 future dollars. We’re assuming an 8% gross annual stock market return, however, if you invest in VTSAX the expense ratio is 0.05 percent annually, so it reduces your annual return to 7.95%. When compounded over 40 years (thanks to this investment calculator for the math), you end up with an astounding $2,132,582.
Scenario 2: Mutual Fund Instead of an Index Fund
However, let’s say instead of VTSAX you decided to invest in a mutual fund with a 1% expense ratio, so your net annual return is now 7%. That 1% fee didn’t sound like much up front, but instead of over $2.1 million in VTSAX, you now have only $1,497,445. You’ve lost nearly a third of your investment just by investing in an actively managed (high fee) mutual fund!
Go with the low-cost index fund.
Scenario 3: Financial Advisor + Mutual Fund Instead of an Index Fund
Now, just for fun let’s say you doubled down and hired a “helper” (thanks to Mr. Buffett for that great term!) also known as a financial advisor and they charged you 1% plus invested you in a mutual fund with a 1% fee.
So your net return is now only 6%. At the end of 40 years, you only have $1,028,571. You now lost half your potential return for absolutely nothing! I can almost guarantee that helper’s “brilliance” wouldn’t have brought you any increased returns over the long-term and the drag of their expensive fees just kills your return.
Go with the index fund.
Related: Investment Fees are Evil
Can You Lose All Of Your Money in An Index Fund?
While it's technicallytrue that no investment can promise that it won't lose all of your money, the chances of that happening with index funds are about as close to nil as you can get.
Why? Because in order for you to lose all of your money in an index fund every underlying holding (company) would also have to drop to zero.
Over the next 50 years, is there a chance that several companies that are currently in the S&P 500 will tank, end in bankruptcy, and leave their shareholders with nothing?
Well, actually, yes.
And this is exactly why investing in individual stocks can be so dangerous.
But the chances of all 500 stocks in an S&P 500 index fund dropping to zero is highly unlikely (that's actually putting it mildly).
- And don't forget that Total Stock Market index funds buy little pieces of nearly every publicly traded company in the U.S., often including over 3,500 stocks.
- The chances of every single publicly traded company in the U.S. going bankrupt at any point in time is nearly a statistical impossibility.
This is the power of diversification. And index funds offer more diversification than any actively managed mutual funds you'll find.
Related: How To Open Accounts With Vanguard, Fidelity, and Schwab
How Much Money Do You Need To Start Investing In Index Funds?
It really all depends on the brokerage company that you use and the specific index fund that you are looking at.
Many popular index funds have a 0$ minimum investment, while some have $1,000 minimum investments or higher.
Vanguard has an interesting setup in that they offer two versions of their index funds--Investor shares and Admiral shares.
- The Investor shares have a lower minimum investment but a slightly higher expense ratio.
- What's really great though is that once your account balance is high enough to qualify for Admiral shares of the fund, Vanguard will automatically graduate you up.
VTSAX, which gets a lot of love around here, is the Admiral share version of Vanguard's Total Stock Market Index fund.
Related: How To Buy VTSAX
What Is The Best Index Fund?
There is no objectively "best" index fund. Since index funds from competing brokers all base their funds off the same indexes, their stock market performances will be nearly identical.
Instead of starting by looking for the best fund, I would first try to decide which broker you want to use for your index fund investing and why. Then once you've decided upon your broker, you can choose which of their index funds to choose by comparing expense ratios and other factors.
To get you started, check out our Vanguard vs. Fidelity guide. Other discount brokers to check out include Charles Schwab, T-Rowe Price, and TD Ameritrade.
Recommended Tools/Resources
Personal Capital--this is our preferred tool for tracking our investments and its free to set up. Check out our full review of Personal Capital here.
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