The 13 Steps to Investing Foolishly

Step 4: Start with an Index Fund

Because the index fund makes for a brainless and respectable choice, it’s really our first-stop recommendation to investors of all kinds, novice and experienced. Factor in convenience, performance, low expense, and simplicity, and these things beat the pants off the two traditional options, brokers and mutual fund managers. — You Have More Than You Think

So let’s review before proceeding.

1st Step. You have a general idea of what it means to be a Foolish investor.

2nd Step. You’ve gotten your personal finances in order, paying down all credit card debt and working to set aside funds for investment over the next five years.

3rd Step. You’ve set reasonable expectations, and you’re going to track your investments against the market.

And now, with a little money in hand, the accounting standard established, and the attitude attuned. what next?

The S&P 500 Index Fund

Allow us to set the market standard for you once and for all. Over the past 50 years, the S&P 500, an index of 500 of the largest and most profitable companies in the U.S. has risen an average of 13.6% annually (with dividends reinvested).

That means that if you invested $10,000 into the S&P 500 fifty years back, today you’d be able to call your discount broker, sell your position for $5.78 million, patriotically pay down your taxes of $1.62 million, and end up with $4.16 million. Sounds great, huh? But most people who have invested in equity mutual funds haven’t pocketed that market average (or anything close to it) — unless they have invested in a specific kind of mutual fund — the index fund.

With a low-cost, passively managed mutual fund that tracks the S&P 500 (the index fund), you actually get the S&P 500 returns,

Over the last 50 years, how have actively managed (read: Wise) funds done? Not as well as the index they’re measured against — not nearly as well.

minus very minimal expenses. The index mutual fund is a computer-driven fund that makes no attempt to do anything except match the market’s returns — there is no highly trained Wise money manager actively making daily changes in the index fund’s holdings.

Over the last 50 years, how have actively managed (read: Wise) funds done by comparison? Not as well as the index they’re measured against — not nearly as well. Managed funds have returned an average of 11.8%, a differential of 1.8%.

But oh what a huge difference that little 1.8% makes over time. Over the last 50 years, $10,000 put into the average managed mutual fund would only have returned $2.59 million, or less than half of what the index did. That’s the power of compounding over time, and that’s the destructive power of what little fees can do to erode your returns. Think of those little managed mutual fund fees as the Colorado River — running through the Grand Canyon year after year after year — eroding your returns until over time a huge chasm has been carved through what might have been.

If you are picking a mutual fund for your 401(k) or 403(b) plan deferrals and there is an index fund available in your list of choices, the Foolish thing to do would be to make it your only choice.

Spiders, Man!

You also may want to consider investing in a close cousin of the index fund — Standard & Poor’s Depositary Receipts. These SPDRs, often called Spiders, are stock-like instruments designed to behave much like the S&P 500 index. They have a few advantages over funds. They trade on the American Stock Exchange under the ticker symbol SPY, and each share is valued at about one-tenth the value of the S&P 500 Index. Read more about them by clicking here.

Indexing Beyond the S&P 500

But are index funds just for the S&P 500? Oh, no. If you can name a measurement of the market, then somebody has probably slapped an index fund on top of it: the Russell 2000 (an index of 2,000 smaller-company stocks), the Wilshire 5000 (the entire stock market — in reality there are about 9,000 publicly traded companies, but the Wilshire 8,934 just wouldn’t sound too good), the Dow Jones Industrial Average. The list of different indices that have mutual funds tracking them is getting longer all the time.

And we like them all. Almost.

Different indices will produce different results over the short term, but various ivory-tower academic studies show that different sectors of the market have more or less produced the same results over longer periods of time. Last year (1998) the S&P 500, which indexes the largest companies in America, returned 28%, the S&P MidCap 400 (which tracks medium-sized companies) returned 9% less. However, over the last 10 years, the S&P 500 has returned 19.20% annually, and the S&P MidCap 400 has returned 19.28%. Pretty darn close.

Sometimes it takes longer for the averages to even out like that. The Russell 2000, the best-known smaller company (or small-cap) index, has returned an average of 12.92% over the last 10 years. Does that mean small-cap companies can’t keep up with bigger companies, or that a small-cap index fund should be avoided? Not if you look at the longer term. Over the last 40 or 60 years, the returns of the biggest and smallest companies are nearly identical.

But watch carefully what some companies are selling as index funds. The real point of investing in index funds is not to try to pick the hot index or to pick the cold index before it gets hot. Putting your money into an index fund — any index fund — delivers great results to the long-term shareholder because index funds keep costs so low. The Vanguard 500 Index Fund has annual costs of roughly 0.18%. Full-price brokerage Morgan Stanley, on the other hand, runs an S&P 500 index fund (buying the exact same stocks as Vanguard’s fund) with annual costs of 1.5% — nearly eight times as much!

A Fool reminds you that the only reason to move beyond the Vanguard 500 Index Fund or another low cost index fund is if you believe you can beat its performance, after all of your investment costs have been deducted: research reports, fax newsletters, financial newspapers, business magazines, etc. If you can’t beat the index, you’d better just join it. and keep adding savings to it each year. In the decades ahead, you (and your heirs) will be happy you did.

Some index funds will allow you to establish a regular account for an initial investment of as little as $500 if you set up an automatic investment plan, adding $50 a month thereafter. If you’re looking to get started investing with an even lower amount, make sure to read Step 5: All About Drip Accounts.

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