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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401k vs IRA: What’s the Difference?

With private sector defined benefit pension plans almost non-existent in today’s workplace, defined contribution plans have become the standard for retirement savings.  Since 1979, when 38% percent of private-sector workers participated in a defined benefit plan (either as the only option or combined with a defined contribution plan), the participation rates have declined substantially while the participation rates in defined contribution plans have risen (See Figure 1 Below).  This trend has shifted the burden of retirement saving from the employer to the employee.

DB-DC Trends 2011 Fig1(Source: Employee Benefit Research Institute)

So, what does this tell us?  It says that we are now responsible for our own retirement.  And the best way to prepare is to take advantage of two types of retirement accounts: the Individual Retirement Account (IRA) and the 401k.  Both types of accounts are geared towards retirement and offer tax advantages as long as you don’t withdraw the funds before age 59 1/2 (you can withdraw the funds but you may owe taxes and penalties on the withdrawals).

But which one of these is the best choice.  Well that, like most things personal finance, may depend on a person’s individual circumstances.  Today, I want to talk about some of the differences between the two to help figure out which one is the best choice. 

401k

A 401k is a defined contribution plan that is sponsored through an individual’s employer; meaning that without an employer, someone can’t contribute to a 401k.  Unfortunately, that means the employer controls the plan and what investments are available to choose from.  So if the only investments in the plan are high fee mutual funds, the employee is stuck with high fee mutual funds. Another potential downfall is that the employer may only offer a traditional 401k (funded with pre-tax dollars) and not a Roth (funded with post-tax dollars) version.  Obviously, this is only a downfall if someone is interested in investing in a Roth 401k.  However, this disadvantage is beginning to disappear as more and more 401k plans are offering Roth.

Of course, there are advantages to these types of plans.  Potentially the biggest advantage of a 401k, is if the employer matches employee contributions up to a certain percentage.  Say my employer matches up to 5% and I contribute to that point, I am making a 100% return on my investment before the money is even put to work in my account.  There isn’t an easier return out there then contributing up to the employer match!  Always take advantage of an employer match, otherwise you are passing up free money!

There are also advantages in relation to the amount that can be contributed per year.  If a person wants to maximize their retirement contributions to the maximum, a 401k offers higher contribution limits compared to an IRA.  For tax year 2014, a person is able to contribute $17,500 into a 401k ($23,000 if the person is 50 or older) while with an IRA, a person is only able to contribute $5,500 ($6,500 if the person is 50 or older).  So if someone wants to put away more than $5,500 in a year, they will either need to go with a 401k or do a combination between an IRA and 401k.

Finally, with a 401k, it is incredibly easy to automate contributions as it becomes a simple deduction off a person’s paycheck.  This is one of the ideas behind why I contribute to my 401k because it is impossible to spend money if it doesn’t make it to you.  I am not responsible for transferring the money from my bank account to my 401k so I know I can’t change my mind and use the money elsewhere.  It forces me to contribute since I would actively have to go and decrease my contribution percentages to be able to get that portion of my paycheck.  Gotta pay yourself first, right?

IRA

Like a 401k, an IRA is a defined contribution plan.  However, unlike a 401k, the individual is in-charge of the account.  An individual can set up an account at a brokerage and invest in a larger variety of options.  But as stated above, a disadvantage to this type of account is that you aren’t able to contribute as much per year.  Also, with an IRA a person is unable to take a loan against the account, which can be done with a 401k.  However, if the IRA is a Roth IRA (funded with after-tax money), an individual does have the option to withdraw their contributions tax and penalty free since those dollars were taxed before being contributed.

So what are the advantages to an IRA?  Well as I touched upon earlier, the flexibility an individual has regarding investments is very much superior to a 401k.  Contributions can be put into a variety of investments, such as index funds, mutual funds, individual stocks, and bonds.  Due to this freedom, IRAs can be a cheaper option since an individiual isn’t locked into potentially more expesive options that an employer plan may restrict them to.

Another benefit, is if a person doesn’t like something about the company their IRA is with, they can move the account.  Don’t like the account with Company X, well roll it over to Company Y.  If a person doesn’t like the options and the company their current 401k is through, they need to complain to their HR department because there isn’t anything they can do.  Once again, an IRA offers more flexibility. 

Taking it Home

So how do you choose which one to use?  Personally, I’ve been exclusively using my 401k while I have been paying off debt.  It is more convenient for me to have my contribution taken straight from my paycheck as I can’t spend it if it never hits my bank account.  I am also lucky that when I joined the company, they were currently overhauling their investment choices and came away offering quite a few low expense options, such as a variety of index funds.  I do have some old, more expensive 401k plans from prior positions that I will be exploring rolling over within the next couple months.  As I am learning is the case with most things personal finance, there isn’t one correct answer one correct answer in regards to which retirement account is the best.  The best option out there for someone all depends on what they have going on.

Which type of retirement accounts do you use? IRA, 401k, or both?  What are your reasons for choosing your option?

*Part of Financially Savvy Saturdays on Femme Frugality and A Disease Called Debt*

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?!).

Follow Wealth Hike on Twitter (@WealthHike)
E-mail Questions or Comments (wealthhike@gmail.com)