It’s a pretty outrageous claim that I made in the title of this post. Index funds can save you (and me) over $200,000 throughout the course of our lives ….
Hmmm … that certainly doesn’t sound true. But, just in case it is, let’s explore the statement. Since I started writing this on Black Friday (the ultimate shopping day here in the United States), this could actually be the biggest Black Friday savings ever!
Before we dive into saving money with an index fund, it helps to know what it actually is. Basically, an index fund is a collection of stocks put together to make up a mutual fund. This fund is designed to track the returns of a stock market index like the Dow Jones Industrial Average (DJIA), S&P 500, or NASDAQ Composite. If the index fund is tracking the DJIA, then the index fund will own the same 30 stocks that are in the DJIA. Not only will it own the same stocks, but it will also own the same percentages of each stock. As of the time that I write this, it will own 8.79% Boeing stock, 7.22% UnitedHealth Group, 5.51% 3M, etc.
Pretty boring ….
When I used to think of the stock market, I thought of people like Gordon Gekko in the 1987 movie “Wall Street“. I thought that people mainly made money in the stock market by buying and selling individual stocks.
Of course, online brokerage firms and mutual funds make it easier to buy and sell stocks. Instead of betting heavily on one company, we can now diversify by buying a variety of companies in a mutual fund. So we don’t need Gordon Gekko in our lives.
Like I said, index funds and mutual funds in general have made the stock market kind of boring. But, boring is good when it comes to the stock market. Since the Great Depression, the stock market in the United States has averaged a 10-11% rate of return. This turns $10,000 invested at age 25 into $542,000 at age 65. Even after inflation, $10,000 still becomes $150,000 in 40 years.
The power of compound interest is a beautiful thing!
So, people can make money in the stock market if they leave it invested for a real long time. This is not exactly ground-breaking information. After all, you may own a 401k through your work and may have seen your investment return soar over the past few years. Even though the stock market has stumbled this year, many people think that our money will grow if we leave it invested for long enough.
But, aren’t I supposed to talk about index funds? After all, I made the outrageous claim that they will save us over $200,000! How can index funds save us that much money?
It’s all about the FEES!
The average mutual fund has fees of about 1% per year. That means that the average mutual fund will charge us around $10 per every $1000 invested, each and every year that we own the fund.
Honestly, the fees don’t sound too bad! I mean, I would gladly pay 1% to get average investment returns of 10-11% per year. I would even use a “loaded” fund, where the up-front fees are over 5%. After all, compound interest would still allow my investments to grow substantially!
The really cool thing about index funds is that their fees are so low. I mean, substantially lower than the average mutual fund. After all, the average mutual fund has to pay a fund manager a lot of money to find stocks to put into the mutual fund. Whether these fund managers come from the movie “Wall Street” or real life, they make a lot of money. With an index fund, the stock choices are already chosen for us. Remember, all the index fund has to do is to purchase the stocks in the appropriate index. Therefore, the fees are extremely low!
Although many companies sell index funds now, the original index fund broker was Vanguard. Currently, Vanguard sells some of the biggest mutual funds, including Vanguard Total Stock Market Index Fund or VTSAX. VTSAX seeks to model the return of the entire United States stock market. The reason why this fund is so great because it has fees of 0.04% per year!
Many financial independence bloggers recommend VTSAX as the main fund to invest retirement assets in.
I have most of my retirement funds in a similar index fund run by Fidelity called Fidelity Total Market Index Fund or FSKAX. This fund currently has fees of 0.02% per year. Basically, I have found that these two funds are almost mirror images of each other. They even had the exact same return over the past 5 years!
Even though the fees for each of these funds are low, how can they save us so much money? When compared to the average mutual fund, these funds only save us $9.60 per every $1000 invested, so how can these index funds save us over $200,000 as I claimed?
Again, we must rely on the power of compound interest and time invested.
Let’s say that the stock market averages a 10% annual rate of return over the next 30 years. After fees, an average mutual fund would return around 9%, while the index fund would return around 9.96%. Over one year, our rate of return would only vary by 0.96%, but this would add up to a significant amount of money over time.
How much money? Well, it all depends on how much we invest.
In 2017, the average income for a family in the United States was around $59,000. I will assume that we invest 15% of this income, or $8,850 per year for 30 years.
After 30 years have passed, the index fund will have approximately $248,000 more in it than the typical mutual fund.
$1,503,000 versus $1,255,000!!!
As I said, compound interest and time are powerful weapons. They have allowed us to turn $8,850 per year into 1.5 million dollars!
Whether we invest more or significantly less than $8,850 per year in our retirement fund, remember that fees are extremely important when investing in mutual funds. They don’t matter too much after one year, but they will add up to a huge amount in 30 years.
Imagine if your retirement is invested in a mutual fund whose fees are significantly higher than average or if you are investing more than $8,850 per year. Instead of saving $248,000, switching to index funds could save you $500,000 or even more! I used to have a fund whose fees were about 1.73% per year. It was a horrible investment, but I changed it after I figured out how important fees are.
So … check into the fees on your investments. See if you can get the same or even better returns by switching to index funds. If you work with a financial advisor who gets paid based on the funds that you are in, he or she will be very reluctant to help you switch. Your advisor will claim that you are missing out on returns that are greater than the average return in the stock market. As I will explore in a future post, this is simply not true! Even before fees, an index fund will end up exceeding the returns of most mutual funds.
As the advertisements say on Black Friday, everything is on sale! Including mutual funds!
Share your investing tips with us in the comments below. What have you done to make sure that you are maximizing your returns in your retirement funds?
And thanks for reading!
~Nathan
Let’s keep living a great life … with the help of money. So what’s next?
- You can travel for free by using rewards credit cards.
- You can get motivated and get out of debt.
- You can check out the next post or the previous post and continue to learn.
But no matter what you decide to do, let’s leave the ordinary behind and take action today!
