What is Index Investing?
Unlike other strategies for building wealth to achieve financial independence, investing in index funds is almost completely passive. Aside from setting up your account, choosing a fund to use, and making frequent investments, there’s really nothing else that you have to do to use this strategy. But, for some reason, those three steps I just listed end up being daunting for many—even some of the boldest people I’ve met.
That’s because, while it’s simple, that doesn’t mean index investing is something you can do thoughtlessly. It requires an incredible amount of patience and resilience to continually invest large portions of your income over several years.
Table of Contents
- Why Your Grandparents’ Portfolio Advice Won’t Go Very Far Anymore
- Live index funds chart
- Your Steps to Get Started
- Investing With Index Funds As Part of a Portfolio
- Best Books to Learn About Investing
- Bottom Line
The Quick Basics of Stock Market Investing
Index investing is a form of stock market investing. Most people are aware of how stocks work—they represent a share of ownership in a company. These shares rise and fall in value and can be traded online.
While most people are aware of stocks, fewer know about investments like mutual funds or exchange-traded funds (ETFs) that investors can use to spread out their investments across many individual companies to reduce their risk of losing money.
- Stocks - Shares of ownership in a company that can be bought and sold. These shares entitle investors to a portion of the company’s earnings
- Bonds - Debt issued by a company. Investors can purchase some of a company’s debt to collect future interest payments
- Mutual funds - Baskets of stocks and/or bonds that issue shares to investors. These funds allow investors to invest in many different stocks or bonds all at once
- ETFs - Collections of stocks or bonds, similar to mutual funds, that can be traded like individual stocks. These funds often have lower costs than mutual funds
Index funds are mutual funds and ETFs that are designed to track big-name indexes like the Dow Jones Industrial or the S&P 500. These index funds are broadly diversified and use complex algorithms to make sure they track the indexes they’re supposed to mimic.
In this article, we’re going to focus on investing in indexed ETFs. Why? Because there are a lot of them, they track underlying indices well, and they’re extremely cost-effective - most can be traded online for free.
We’ll also be focusing on them because they’ve been used by countless people to achieve financial independence and/or retire early.
Why Your Grandparents’ Portfolio Advice Won’t Go Very Far Anymore
When most of our parents and grandparents came of age, they were entering an economy that was booming, riding a wave of population growth for which baby-boomers were named.
Starting in the early 1980s, when most baby boomers were just beginning to invest in earnest, people really couldn’t go wrong with their investments (unless they got suckered into something exotic like private partnerships, in an effort to earn outsized returns).
Back then, the Dow Jones Industrial Average was hovering just under 1,000, and had only gone above 1,000 a handful of times. IBM stock was trading at under $14/share, and AT&T was hovering in the mid-single digits.
As of this writing, IBM is now over $105/share, AT&T is in the high-20s, and the Dow is still over 20,000 even after its recent drop.
Live index funds chart:
Even conservative investors could earn good returns 35 - 40 years ago. Savings accounts were yielding 4 - 5 times as much interest as they are now. Even certificate of deposit (CD) rates were in the double digits.
In other words, when now-seniors started investing, they could make just a few investments and watch their money go up. It typically doubled every few years.
Now, compare that with the past 10 years. Most big-name stocks have made investors almost no money. Some are even down over the past 10, 15, or even 20 years. Millennials and gen-Zers have come of age during 2 significant recessions, interspersed with several less-notable recessions.
And, oh yeah, multiple wars going on continuously.
To be certain, the economy has changed since the years when previous generations were working and investing. Our outlook has changed as well, and so have our investments.
Enter, Index ETF Investing! Here are Your Steps to Get Started:
If you decide that index investing is a strategy you want to use, there are just a few steps that you need to do to get started.
Pick a platform
Before you can invest, you have to decide what company you want to use for holding your investments and facilitating your trades. For this strategy to be successful, you need to keep long-term costs to a minimum, so it’s best to stick with discount brokerage platforms like ETrade. Learn more about choosing a platform below.
Visit the provider’s website & click “open an account”
Once you pick a platform, you need to open an account through the provider’s website. You’ll need to provide some personal information including your social security number or tax ID number.
Link a bank account
In order to fund your account, you’ll need to link your new investment account to a bank account - preferably the one where your employment checks are deposited.
Select investments
After you have your account set up and ready to fund, you need to pick an index fund to invest in. We’ll talk more about this later, but it’s important to focus on low-cost, diversified funds. The most common FI/RE favorite is VTSAX, but others include VTIAX, VBTLX, and VASGX. Learn more about picking investment funds below.
Schedule regular investments
Now that you have your account set up, your investments selected, and your bank account linked, the only thing left to do is to invest. A lot. And often. For this strategy to work, it’s important for you to save a sizable portion of your income each month. Having funds automatically transferred to your investment account every month (or twice a month for each pay period) is typically best practice, but additional investments are both allowed and encouraged.
Don’t forget when using this strategy that you’re trying to build a portfolio up to 25x your average annual expenses. If you want to use this strategy to achieve financial independence within 10 or 15 years, you need to get aggressive both with increasing your savings rate and cutting expenses.
Choosing a Platform
Deciding which firm or platform to use for your index investing can sound tricky, but it’s simpler than it sounds. There are only really three things you need to worry about:
- Minimizing cost - Can you regularly transfer money to your account and invest without paying fees or commissions?
- Availability of funds - Will you get access to the funds you want to invest in?
- Tech - Are the provider’s website and/or mobile app easy for you to use?
If you want to use this strategy to start building your portfolio, you really have to focus on using web-based, cost-efficient providers. This typically rules out working with a financial advisor, which may require paying additional fees.
Some of the best platforms for using this investment strategy are:
- ETrade - ETrade is one of the original discount brokerage firms. It allows you to trade tons of mutual funds and ETFs for free and also recently got rid of commissions on stocks that trade on exchanges. This includes most stocks that people know (AT&T, IBM, Tesla, Apple), but it’s worth mentioning that trading individual stocks can be very volatile.
- Charles Schwab - Schwab also now includes TD-Ameritrade, which would’ve been another one of our recommendations. TD is another discount brokerage, and Schwab has also been on a mission to reduce fees for investors lately. Both firms recently got rid of commissions on most stocks, along with ETrade. Investors can now trade tons of mutual funds, ETFs, and stocks without commissions. Plus, you can bank with Schwab if you have need of their other services.
- Vanguard - If you prefer not to go through a third-party platform, you can always go direct to the supplier. Vanguard’s founder, Jack Bogle, is considered the father of the index fund. He founded Vanguard to give investors access to diversified, low-cost funds. If you know you want to use Vanguard’s funds (and their’s are some of the best in the business), consider going straight to Vanguard rather than an independent custodian like ETrade or Schwab. You’ll only be able to invest in Vanguard funds, but for many FI/REers, that doesn’t matter — they’d use Vanguard anyway.
Sign up for Vanguard with our code: THINKSAVERETIRE15 for 15% off!
Picking a Fund
Just as important as picking a platform is picking the fund or funds that you’ll invest in. Most people who use this strategy only use one, but you may use 2 or more if you prefer to spread out your investments for lower risk.
When choosing a fund, be sure to limit your options based on a few overarching metrics:
- Reputable company - Avoid funds from smaller, lesser-known companies.
- Commission-free investing - If you have to pay every time you invest, it will kill your long-term returns.
- Low expense ratio - Management fees for mutual funds or ETFs can run to over 1%, but the lowest-cost options can be significantly lower than that. Try to focus on funds that are under 0.10% - 0.15%.
- Diversification - Look for funds that invest across industries and even borders. The more focused your investments (by industry, geography, or asset class) the higher your chance of loss.
Some of the most popular index funds for passive investing to achieve financial independence include:
- VTSAX - When it comes to investing in index ETFs or mutual funds to build wealth for financial independence, most investors need look no further than VTSAX. The fund is designed to be diversified across the entire U.S. stock market, investing in companies of all sizes. It also has one of the lowest expense ratios of any fund around—just 0.04%. There’s even a popular FI/RE saying about it.
- VTIAX - VTIAX invests in international stocks, not U.S. companies. The fund has just an 0.11% expense ratio. It’s great for investors who are skeptical about U.S. stocks, think they can get better returns investing outside the country, or just want broader diversity.
- VBTLX - This fund is income-oriented. It invests in high-grade corporate bonds and treasuries and carries a 0.05% expense ratio. It’s best for investors who want more safety than investing in stocks.
- VASGX - VASGX is actually a fund of funds that invests in most of the funds named above. Because it has the expense ratios of underlying funds in addition to its own, VASGX has a slightly higher expense ratio of 0.14%. It’s a good option for investors who think all of the funds listed above sound good but don’t want to figure out how much to allocate to each or do their own rebalancing.
You may notice all of the funds named above are Vanguard products. And no, I’m not on their payroll. I never have been. In fact, when I was in the industry, I did most of my business with a totally different fund company. Nevertheless, Vanguard is THE fund company when it comes to low-cost index investing.
Index Investing And Your Life
Common wisdom is that those wanting to achieve financial independence need to build their savings until they reach 25x annual expenses. The thought is that, once you’ve done that, the income from your savings—even if you invest conservatively—should more than cover your annual expenses indefinitely.
Regarding the 25x rule, there are 2 sides to this equation.
One side of the equation, this strategy is meant to address head-on: building savings. Investing a portion of your earnings to make money with interest, dividends, or just stock prices going up (in the investment industry we call this capital appreciation).
But this is only half of the equation.
The other half is lowering expenses.
Case in point: If you have average annual expenses of $40k, you would need to save $1 million in order to achieve financial independence. But, if you can cut your expenses to $25k per year (still a pretty decent lifestyle), you’ll cut your savings needs by $375k to $625k.
For those who want to achieve financial independence sooner than 15 or 20 years from now, this highlights the importance of reassessing lifestyle expenses. You have to decide what you’re willing to give up in order to be free of the need to work.
The strategy is specifically designed so you don’t have to make a high salary or pick the right investment to get rich. It’s all about cutting expenses, dedicated a substantial portion of your income to savings, and being persistent.
Dollar-cost Averaging
Many readers worry about the market going down. They consider near-term market pullbacks (short-term falls in stock prices) detrimental to their efforts to build wealth.
However, more astute investors recognize that short-term market volatility—even if it lasts several years—represents an opportunity. These pullbacks offer investors a chance to buy cheap. If you set yourself up for regular investments of a predetermined amount of money.
When the market goes down, share prices decline. This means that you can invest more shares with the same amount of money, which allows you to profit even more when the market recovers. And, even though the market has had its periods of poor performance, in over 200 years the U.S. stock market has never failed to recover.
It’s important to remember, too, that when you use this strategy, you are investing for the long term. When you use index investing to build wealth, you’re always investing. You’re never trading, never leveraging, never hedging, never selling. All you’re doing is buying. As much as you can, as often as you can.
Investing With Index Funds As Part of a Portfolio
Most people who use this strategy successfully use it for all or most of their net worth. The strategy requires dedication, so it typically works best when you aren’t distracted by other things. However, that doesn’t have to be the case.
The great thing about index investing is that it can be used in conjunction with other strategies, or for purposes other than saving for retirement. For example, you can use index investing to boost your savings for a down payment on a rental property or start your own business. You can even use this strategy for MOST of your savings and then invest in riskier things using the same platform, like individual stocks or options.
In the end, it’s all about what you’re comfortable with—and what setbacks you’re willing to tolerate to achieve financial independence faster.
Granted, these aren’t recommendations. People who use index investing to achieve financial independence should plan to stick with it for the long term to be dedicated and use it for a significant portion of their net worth.
What an Index Investment Strategy Isn’t
Given the allure of stock market investing as a get-rich-quick scheme, it’s important to remember that this strategy isn’t that. There are all kinds of behaviors that should be avoided when using index investing. These would include stock-picking, active investing, investing in alternative assets, options trading, penny-stock trading, etc.
Additionally, this is a difficult strategy to use for achieving financial independence while also living lavishly. If you want to learn how to invest in index funds in order to build substantial wealth , you’ll have to invest a substantial portion of your income. This means reducing expenses and slowing your spending so you can invest as much as you can as often as you can.
Best Books to Learn About Investing
This book is all about the degree of randomness exhibited in stock prices. The author uses this to show that it’s essentially impossible for investors to beat the market over the long-run. This book serves as a how-to guide for building a diversified portfolio to achieve long-term gains.
Business Adventures: Twelve Classic Tales from the World of Wall Street
I’m actually reading this one right now. It’s a little dated, but super interesting and still remarkably relevant for today’s business climate - especially about the use of leverage.
Reminiscences of a Stock Operator
This one is also a little dated, but shares lessons learned up-close by a man who spent his life working in the stock market, starting very young.
Little Book of Common Sense Investing
This one is by Jack Bogle, the founder of Vanguard. It’s not too old and is considered a classic among “Bogleheads.”
This is another oldie and a little tedious, but a very insightful book. I personally re-read it every few years. It holds some great lessons about setting yourself to a purpose and working toward it diligently.
This one is a monster and not for the faint of heart. It is the Bible for valuing securities. It was first published in 1934 and was written by Ben Graham and David Dodd, who are considered the fathers of value investing. Graham was Warren Buffett’s mentor.
This is the story of Warren Buffett’s career, complete with lessons learned along the way.
This is a good one, but so is pretty much anything by Andy Kessler.
This one holds some great insights into why it’s best not to try to beat the market. Plus, anything by Michael Lewis is well-researched and insightful.
This is a thinker and an instant-classic from Nasim Taleb. It’s philosophical but reinforces why you shouldn’t expose yourself to too much risk or chase returns. There are plenty of risks you can’t control, so minimize the ones you CAN.
Bottom Line
Index investing is extremely complicated. There are lots of principals at play, millions of risks to worry about, and the future is ultimately unknowable. However, this strategy is also startlingly simple to use. All you have to do is pick a platform, pick a fund, and start investing. As much as you can, as often as you can.
Granted, the strategy also has its drawbacks. Returns can be lower than some other forms of investing. But it’s easy, it’s passive, and you can do it from anywhere. All you have to do is set your mind to it and be persistent.