It's Still January, But We're Moving On!

Spring is near. I can feel it! No, actually I live in Connecticut and I can’t. New Englanders don’t get a real “spring” per se. We get a couple of warmer days, and then back to cold, then suddenly it’s 85 degrees and you’re sweating profusely through your clothes.

Either way, I’m manifesting warmer weather and moving forward — which means we’re on to our next big financial topic!

Drum roll please……

INDEX FUNDS!

Perhaps you’re already well versed in index funds. Perhaps you know the term but never quite understood what they are and how they operate. Have no fear, whether you’re an old pro or an investing newbie, we’re going to cover all things INDEX FUNDS over the next few weeks.

Let’s start at the very beginning:

What do we mean when we say “the stock market is up/down today”? When people talk about the movement of the market, they are referring to indexes (or indices if you’re nasty). The most famous indexes include the S&P 500, the Dow Jones Industrial Average, NASDAQ, and the Russell 2000. You’ll see these in the news often.

The indexes are essentially groupings of publicly traded companies (companies where anyone can buy or sell shares, a.k.a. stocks). For example, the S&P 500 is a grouping of the 500 largest publicly traded companies in the United States. What the S&P 500 index does is measure the total market value of these 500 companies. This is important because it lets us know the general health and wellbeing of the market, particularly relating to the United States. The S&P 500 is weighted, so bigger more valuable companies have a larger effect on the index than the smaller ones.

Most folks use the S&P 500 as a way to compare how other investments are performing relative to this index. This is called “benchmarking”.

Different indexes measure different things - while the S&P 500 tells us about the health of the US stock market, there are indexes to tell us what’s going on in different sectors (technology, real estate, energy, etc.), countries, regions of the world, and even indexes to cover what’s happening in each exchange (where stocks and bonds are bought and sold).

Why is this important?

Because you have to first understand what an index is what they are used for. Now, you can more fully understand an Index Fund. An index fund tracks a particular index. Let’s use the always popular S&P 500 for example. There are a bajillion S&P 500 index funds to choose from. Every major financial services company has at least one. Vanguard, Schwab, Fidelity, etc. They all offer their own version of S&P 500 index funds.

Okay, lady, get to the point. What is an index fund?

An index fund is a type of investment that pools investor money for the purpose of investing that money in stocks that exactly track an index.

Let me break that down a bit more. Let’s use Vanguard’s S&P 500 index fund (VOO).

How does this index fund work?

Well, first it tells you what it’s going to do — it’s going to track the S&P 500. How does it do that? Thousands (actually, probably millions) of people say to Vanguard, “Hey, I’m going to put X amount of dollars into the fund.” Vanguard then takes all the money from these investors and purchases shares of all the companies within the S&P 500.

Let’s say Apple stock makes up about 7% of the S&P 500. That means the Vanguard S&P 500 index fund is going to take the investor money and 7% of it will be allocated to Apple stock as well. The fund will copy the index. As the S&P 500 makes changes, so will the fund.

What is the purpose of this?

There are a few reasons why index funds are great for everyday investors like you and me. First, if we were to buy individual shares of stock in every single S&P 500 company on our own to replicate the index it would cost A LOT OF MONEY. This method does exist and it’s called “direct indexing”. Ya gotta have some serious dough to make it work though. Index funds, however, provide a low-cost way to invest in a lot of companies and track an index. Right now you can buy one share of VOO for about $550. If you were to attempt “direct indexing”, one share of Apple alone is currently about $240! If you were to try to direct index the S&P 500, the price to do so can run quite high.

Why should you track an index via an index fund?

Diversification! We don’t have a crystal ball. I can’t tell you what companies are going to do well or fail in the next year, ten years, and beyond. No one really can. By purchasing shares of an index fund, we can buy a piece of hundreds or thousands of companies. We are then placing our limited eggs in many baskets and giving ourselves the best chance for long-term success.

You might say, “Catie, doesn’t this lower our chances of hitting it big!?” Not really. Diversifying our investments through something like an index fund, historically has better results than choosing a few companies we think are going to do well. What I’m saying is, it’s less of a gamble. I love to gamble by the way. I just want to limit the amount of gambling I do with my retirement funds and kids’ college money. The S&P 500, since it began, has averaged about 10% in annual return. Yes, some years are way up and others are way down, but averaged all together we get just about 10%. This is a GREAT rate of return for long-term investors (notice how I keep bringing up long-term…there’s a reason for this!! We’ll discuss more next week).

Are you ready to have your mind blown by the magic of math and compounding over time? BUCKLE UP, BUTTERCUP.

If we invested $10,000 per year for 40 years at this rate of return (10%), you’d end up with $4.425 MILLION DOLLARS. Math is amazing. Compounding is even more amazing-er. Giving yourself time is the most amazing-er-ness.

Here’s the TL;DR:

Index funds make investing simple, they provide diversification, and a low-cost entry point for investors like you and me. Over a long period of time, you’re likely to do pretty damn well.

Next week, we’ll discuss more on how to choose an index fund that’s right for you and your investment portfolio and why investing for the long-term is so important.

*MANDATORY DISCLOSURE: Remember, this is all for educational purposes only. In no way am I providing investment advice or soliciting in any form. I will not go to white collar jail for you. The goal here is to learn. All investing carries risk, so you MUST do your research and understand before you begin.

I love to love ya, let me know if you have questions!!! Talk to you next week :)

-Catie