How do I choose a good index fund to invest in and where should I buy one?
I am 25 years old and have a decent amount of savings in a variety of different 6-month and 1-year CDs. I would like to move some of my savings into an index fund to get a higher return on my investments. I am wondering what entails a good index fund and how/where I should buy one.
You have an lengthy time horizon, which argues strongly for a 100% allocation to equity (stock) investments. You should consider a combination of investments in the U.S., international developed countries, and international emerging countries. In all cases, you would want low-cost mutual funds or exchange-traded funds. For the U.S., take a look at VTI (Vanguard Total Stock Market exchange-traded fund - expense ratio 0.04%). For overall international, see VXUS (Vanguard Total International Stock Market exchange-trade fund - expense ratio 0.11%). For emerging markets, VWO (Vanguard FTSE Emerging Markets exchange-traded fund - expense ratio 0.14%). The simple solution for handling your trading would be to go to Vanguard Brokerage Services https://investor.vanguard.com/investing/online-trading/.
If only it were that easy everyone would be driving a Mercedes! Just for background info understand that anyone can create an index...and sometimes I think about everyone has. An index is simply a rules based systematic way of buying and selling a specific set of investments. An index fund then replicates the buy and sell rules created for the index. Most Exchange Traded Funds are based on some index.
Index funds are generally inexpensive, a big plus. But the most popular index, the S&P 500 is also very volatile. Yes it is doing great now...but only a fool would invest assuming it will do nothing but go up in value into the foreseeable future. From 2000 - 2002 the S&P 500 dropped about 50% and again from 2007 - 2009. A holder of the index on January 1, 2000 did not see their account show a permamnet gain until 2013! Despite this, the S&P 500 has historically outperformed other asset classes over the very long run - 20 year+ periods of time. Just want to make sure you understand the risk before jumping in.
One way to lower your risk is to dollar cost average into the index. One way to do this would be to move money into a savings account. Open an account directly with Vanguard, and make an initial investment into their S&P 500 index fund. On the application you can sign up for systematic investments. Have them take an amount from your savings account every month to invest in the fund. I would divide the amount you want to ultimately put in the fund by 36 and have that amount invested monthly over the next three years. If the market crashes you'll have cash available to buy in at the bottom.
This is an excellent question and one that I wish more 25 yr olds would ask!
Here are my few points to remember. The first thing is the index itself. The index is simply a basket of stocks that represents the stock market, and the key thing about that is to remember that someone chooses what goes into the index. For Example, the Dow Jones index has replaced companies that are underperforming regularly since its inception. I actually like the Dow Jones as an index for very long term investors since it is very noteworthy when one is moved in and out, and it makes a big difference in the performance of the index when a good company (Like AAPL) replaces an underperforming one (Like C). So to your question of what entails a good index fund in my mind it is to use the fund with low fees that you can easily track. There are a number of online brokerage firms (Fidelity, ETrade, Ameritrade, Scottrade, Tradestation, Interactive Brokers..... ect) where you can purchase a fund for a very small commission, some as low as $1.00 for 100 shares.
The two things I would stress are:
1. I believe the ETF is a better choice than a mutual fund for a variety of reasons (Fees, Taxation, intraday tradability)
2. No matter how you choose to invest, always have a "line in the sand" where you choose to limit your exposure in the event of a market downturn. I do not believe in simply "dollar cost averaging" and buying more as it goes down. I believe in getting out of a losing position and getting back in once it has fallen to a level you are comfortable owning using some sort of systematic process.
There are indices for everything, from stocks to bonds, to real estate or commodities. They all have different risk/reward trade-offs and perform differently depending on where we're sitting in the economic cycle. Assuming you are talking about buying a stock index fund to invest in the US stock market you could get a lot of diversification at a very low cost by considering an exchange traded fund. Generally, stock index ETFs have lower internal expense ratios than mutual funds. Internal expense ratios are the part you don't see. Instead, when you see performance on your statement, you're seeing performance net of that expense ratio. Some that you might look at would be SPY which tracks the S&P 500 (so has 500 holdings) or VTI which tracks the CRSP US Total Stock Market Index which has over 3,500 stocks. Both have merits, and there are lots of others to consider.
One thing that buying an index fund will not do for you: It won't manage your emotions. We're long overdue for a stock market decline and US stocks are heftily overvalued according to some measures. From the top in 2007 to the bottom in 2009, the loss on a S&P 500 index fund was over 50%. However, those losses were only locked in when investors sold S&P 500 index funds on emotion while the prices were down. Wise investors who purchased in 2007 at the top enjoyed a doubling of their initial investment as of September of this year. That's just a little less than 10 years. The key is, those investors held through the painful dip, even when they saw their investment values cut in half.
In short, you may be buying at or near a market high, but, the market always goes back up eventually. So, ensure you have cash set aside for emergencies so you don't have to sell to make cash if the markets go down. Try to manage your emotions through the next downturn when it arrives and keep yourself from irrational selling.
Also, consider costs such as commissions. For example, if your trades are $7 and your initial investment is $700, then you would have spent 1% to get in. Then, let's say it doubles in 10 years to $1,400 and you have to spend $7 to sell, you will spend 0.5% to sell. So, don't spend $7 to make $100 trades or to dollar cost average in to the investment. I assume you are cost-sensitive since you are considering an index fund. Spending a large amount in commissions to make your purchases will negate any goal you had of cutting costs to invest.
Based on your age, I highly recommend a 90-100% allocation in an assortment of stock funds (ETFs have additional advantages over mutual funds). While an index fund is simple, you can diversify your portfolio further with potentially higher performance by having an international, growth, and value fund along with or in lieu of the index fund (typical overlap that may be unnecessary). Beware of commissions and transaction fees or high initial investment minimums. You can learn more about ETFs and portfolio options at our website.