Index fund investing
One fund can hold a whole market. This covers weighting, diversification, cost and the risks that remain.
Index Fund Investing
A fund that charges 1.05% a year instead of 0.05% leaves about $184,000 behind on a $100,000 investment held for thirty years. Same index. Same shares. The difference is a fee you agreed to once and then stopped thinking about.
Owning the whole market is not a compromise you make because stock picking is hard. It is the position that wins most of the time, and it costs less than the alternative in every year you hold it.
What you own when you buy the market
An index fund holds every stock in an index, in proportion to each company's size. The largest company gets the largest weight, and when the index provider adds or removes a company, the fund follows. Nobody at the fund has an opinion about which stock will win next year, because nobody needs one.
- 01The index sets the rulesWhich companies qualify, published in advance
- 02Size sets the weightsA bigger company gets a bigger share of the fund
- 03The fund copies the weightsYour money is spread in the same proportions
- 04The index changes, the fund followsAdditions, removals and resizing happen automatically
Winners grow into a larger share of the fund on their own, and losers shrink out of it. You never have to decide when to sell either.
| Index | What it holds | Roughly how many companies | A fund that tracks it |
|---|---|---|---|
| S&P 500 | Large US companies | 500 | VOO |
| MSCI World | Developed markets in 23 countries | 1,400 | URTH |
| FTSE All-World | Developed and emerging markets together | More than 3,000 | VT |
The weighting does the work stock pickers get paid for. If a company grows to 5% of the world's stock market, you own 5% of it without buying a single share yourself. If it shrinks, your exposure shrinks with it.
That is uncomfortable for anyone who likes having a view. You will own companies you dislike and companies you have never heard of, in exactly the proportions the market has settled on. In exchange you never have to be right about any single one of them.
The one number you control
Nobody can forecast next year's return. Everybody can read an expense ratio, and over a long holding period that ratio does more damage than most investors expect.
- 0.05% fee
- 1.05% fee
The gap is $65,667 after twenty years and $184,349 after thirty.
Illustrative. $100,000 at 7% a year before costs, fee subtracted from the return each year, no taxes.
Both lines start from the same $100,000 and earn the same 7% before costs. The expensive fund is not badly run and it is not unlucky. It charges one percentage point more, every year, on a balance compounding is trying to grow, and one percent of a growing balance is a growing amount of money.
- Annual cost
- Better: Around 0.05% for a broad fund
- Around 1% is common
- Sales charge
- Better: None when bought directly
- Up to 5% on some share classes
- Beat the S&P 500 over 15 years
- Better: Matches it, minus a small fee
- Roughly 1 in 10 large-cap funds did
- What you need to be right about
- Better: Nothing except staying invested
- Picking the manager, then keeping them
VerdictAn active fund has to beat the index by its extra cost every single year just to draw level. Over fifteen years, about nine in ten large-cap funds did not manage it.
Cost figures illustrative. Outperformance: S&P SPIVA U.S. scorecards, large-cap funds over 15-year periods.
S&P's SPIVA scorecards have repeatedly found that close to 90% of large-cap US active funds trailed the S&P 500 over 15-year windows. The results come out twice a year, and they have not changed direction in twenty years.
Fees also hide outside the expense ratio. A platform fee, an advisory fee of 1% a year, the spread on every order and the fund's own trading costs all come out of the same pocket. An advisory fee of 1% on top of a 0.2% index fund is a 1.2% annual drag, which puts you back on the expensive line of the chart above without owning a single expensive fund.
Three funds, one decision
The standard recipe fits in one bar:
- US total market
- International developed and emerging
- US bonds
Thousands of companies, one order a month and about fifteen minutes of upkeep a year. The equity and bond funds in it cost under 0.25% a year, the cheapest under 0.10%.
One common mix, not a recommendation for your age or goals. Example funds: Vanguard Total Stock Market ETF, Total International Stock ETF, Total Bond Market ETF.
If even three funds is too many, use one. A global all-world fund covers developed and emerging markets in a single holding and rebalances internally. You give up the ability to tune your bond weight, and you gain a portfolio you will never tinker with.
The five percent that never arrives
A front-end load is easy to miss because it is taken before your money is invested. You hand over $10,000, $500 goes to the sales channel and $9,500 goes to work. That $500 does not just disappear once. It disappears along with everything it would have earned.
The $500 leaves your account on day one. What it would have earned keeps leaving for thirty years.
Illustrative. $10,000 purchase with a 5% front-end load, 7% a year after that.
Stack a load on top of an active fund's expense ratio and the arithmetic gets ugly. Take $10,000 at the same 7% before costs over thirty years. At 0.05% a year it ends around $75,000. At 2% a year, which plenty of actively managed funds charge once everything is added up, it ends around $43,000. Both figures assume the manager matched the index before costs, which most do not.
Getting started, in order
Open a brokerage account
A taxable account at a low-cost broker is enough to start; use a 401(k) or IRA first if you have one.
Buy one broad fund first
Get the first contribution invested before you optimize anything.
Add the second and third fund once the first is running
Splitting $200 three ways is a distraction, not diversification.
Automate the purchase
Same date as your payday, same amount, every month.
Check it once a year
Weights drift. Fees do not, unless you change funds.
The mistakes are predictable, and all of them are behavioral. Checking the balance daily turns normal noise into a reason to act. Selling in a bad month turns a temporary loss into a permanent one. Chasing last year's best fund buys returns that already happened. Owning five funds that hold the same companies adds paperwork, not diversification. Waiting for a better entry point is a bet that you can time a market professionals fail to time.
Where you hold the funds matters nearly as much as which ones you pick. Retirement accounts and taxable accounts treat the same dividend differently, so bonds and other income-heavy funds usually belong in the 401(k) or IRA, and broad stock index funds, which pay little and rarely distribute gains, suit the taxable account.
Index investing asks you to accept average returns before costs, and then hands you above-average returns after them. That is the entire trade, and it works because it does not depend on you being clever about anything except staying invested.
56 more deep dives are in the Navigator library.
