Let’s Talk About…Index Funds

ID-10043721One of the most beneficial items I discovered when I started reshaping my investing philosophy has been index funds.  For most of my investing life, I believed that the only true way to invest was to buy and sell individual stocks.  It didn’t help that I was overconfident that since I was an accountant by trade, I could easily analyze annual reports.  Once I was introduced to the world of index funds, everything I was discovering just made sense.  Index funds offered diversification that I just couldn’t match in my taxable account.

So what are index funds?  Well, according to Investopedia, “‘Indexing’ is a passive form of fund management that has been successful in outperforming most actively managed mutual funds.”  So an index fund is a mutual fund or ETF (exchange-traded fund) that is built to track a specific index, like the S&P 500 or Russell 2000.  So instead of investing in a single individual company, if you invest in an index fund, you will be investing in a much larger pool of companies.  For example, if you invest in a S&P 500 index fund, you will be buying a small portion of the companies that comprise the S&P 500.  This diversifies you into many different industries and can help off set losses that occur in others.

Advantages of Index Funds

  1.  Cost – One of the main advantages of using index funds is that since they are passively managed, their expenses are normally
    much lower than actively managed funds.  The lower the cost, the more investment is left to compound over the
    years.  Actively managed funds normally will have many transactions during a year which will lead to higher fees, thus lowering your annual return.  Many actively managed funds can have expense ratios north of 1% while many index funds are around 0.20% or lower (especially Vanguard funds which are normally some of the lowest in the industry).
  2. Regularly Beat Actively Managed Funds – According to “The Case For Index Fund Portfolios“, a whitepaper by Portfolio Solutions and Betterment, passively managed index funds outperformed comparable actively managed portfolios 82%-90% of the time over the period of 1997-2012.  The study also found that the longer investors held those investments, the better the change of beating the actively managed funds.  Index funds hold the advantage of being able to hold onto investments for the long-term and are able to take advantage of compound interest.

Disadvantages of Index Funds

  1. No Big Winners – Since you are investing in specific indexes, you won’t be hitting those big winners on individual stocks.  A big gain in one stock may not move the needle on your investment since you will be invested in a larger amount of stocks.  Investing in index funds means passing up those large potential gains (or losses) for lower, steady gains.
  2. Under Performance – Since index funds have costs, those costs will go against your gains, leading to a slightly lower return that the specific index your fund is targeting.  This under performance can be managed by searching our for lower cost funds, but you will always incur some sort of cost.

As you can see, index funds should be an important part of any portfolio.  With their ability to keep costs low so expenses don’t cut into your gains long term, you are better able to take advantage of compound interest and keep more of your gains.  I used to think that the best way to invest was by picking individual stocks, but I am realizing that using index funds is the more practical avenue to help grow my wealth.

Do you use index funds?  How do you incorporate them into your overall investment strategy?

Photo Source: Sujin Jetkasettakorn

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Wealth Hike – The Beginning

Welcome to the debut of Wealth Hike – a personal finance blog set out to help educate others on the different aspects of personal finance.  I’m Thias and I will be your (hopefully) decently informed guide to wealth building.  I’m from Northeastern Wisconsin, where I live with my wife (Nikki) and dog (Murphy), and work as an accountant in the manufacturing industry.

Nikki and I-2

My Story

While growing up, personal finance or investing where never common topics in my home.  I was always encouraged to save money but was never told what to do once I saved it. In college, as most students these days, I paid for just about all of it through students loans and the little extra money I made while working at a gas station.  Upon graduating, I left to start my career with 30k in loans and little idea on how I should proceed.  On top of that, I was newly engaged with a fiance working at getting her Masters and her own set of loans.

So, long story short, we were your typical graduates – lots of debt, little in savings, and no idea where to go financially from there.   So I put away money in my 401k, started making loan payments, and saving what I could.  No real plan, just doing what I always thought I was suppose to.

How Did I Get Here

Blogging has always been sitting in the back of my mind.  My wife runs a healthy living blog (www.grabyourkicks.com) and always talked about how freeing it was to write down her thoughts and ideas.  So you can say that I have been surrounded by blogging over the past year.  The idea was there, but I wasn’t sure what I could add to the personal finance world.  Then, a couple months ago, I found a couple podcasts that changed my view on personal finance and helped inspire this blog.  I began listening to the Listen, Money Matters and Stacking Benjamins podcasts.  These two podcasts changed the way I had been viewing debt, investing, and overall wealth growth.  All of a sudden, the idea of investing in individual stocks instead of index funds lost its appeal.  I thought more about paying off debt and building wealth than finding the next hot small-cap stock.  Discovering these two new sources of information helped me focus on what I actually wanted and to work at starting to develop a plan.  What better way to hold one self accountable than by documenting their journey along the way?

Where Do We Go From Here

I hope that you will join me as I begin my journey of learning how to better manage and grow our wealth.  I hope that I might be a resource to readers out there that are also looking to do the same.  Feel free to send in questions/comments and connect with me on social media.  I see this as a great opportunity to learn new ideas and techniques and be able to pass along that information to others.  Now it is time to see what we can do to give our wealth a hike (see what I did there?!).

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E-mail Questions or Comments (wealthhike@gmail.com)