By Dan Miller, WCI Contributor
There are a wide variety of types of assets where you can invest your money. Stocks, options, real estate, cryptocurrency, money market funds, bonds, and cash just to name a few. As you progress through your medical journey and start making more money, it's important to make smart choices about where you invest. A few small mistakes in how you invest your money can cost you hundreds of thousands of dollars over the course of your life and delay your retirement by years. That's why buying index funds could be an important move for high earners. Here's how to do it.
What Is an Index Fund?
An index fund is a mutual fund or exchange-traded fund (EFT) that is set up to closely mirror a published index. Common index funds are those that track the S&P 500 index or the Dow Jones Industrial Average (DJIA). While it would not be feasible for most investors to individually buy shares of stock in all 500 companies on the S&P 500, an index fund allows you to achieve the same goal by buying only one fund that tracks those 500 companies.
How Do Index Funds Work?
An index fund is a type of mutual fund that is passively managed. With many mutual funds, the fund's portfolio manager actively buys and sells specific stock or other investments. In contrast, an index fund only changes when the underlying benchmark fund changes or when past results require a rebalance. This keeps the fees of an index fund incredibly low which helps your overall performance.
Do Index Funds Pay Dividends?
Whether an index fund pays dividends will depend on the specific index fund you're talking about. Generally, any index fund that holds stocks, bonds, or other investments that pay dividends will pay dividends as well. Check the details of any fund where you're considering investing to determine whether these dividends will be paid out to you or reinvested.
How to Buy Index Funds
It's actually very straightforward to buy index funds—most index funds have a regular ticker symbol and can be purchased with just about any brokerage account. For example, Vanguard is a very popular index-fund company. Here are a few of the index funds that they offer:
- VFIAX—S&P 500 traditional mutual fund
- VOO—S&P 500 Exchange Traded Fund (ETF)
- VLCAX—Large Cap Index traditional mutual fund
- VONE—Russell 1000 ETF
- VTSAX—Total Stock Market traditional mutual fund
- VTI—Total Stock Market ETF
As you can see, index funds are available both in a traditional mutual fund format as well as the newer ETF format. Learn more about how to decide between mutual funds and ETFs.
Why Invest in Index Funds?
For many casual investors, investing in index funds is one of the best investment strategies they can make. Unless you have specific knowledge of particular companies or spend a lot of time researching individual stocks or stock strategies, you're highly unlikely to beat the market. Over the long run, studies have shown that index funds beat as many as 80%-90% of their actively managed peers, and that's before taxes. An index fund is set up to actually track the market itself, so when you invest in an index fund, you are guaranteed the same results and performance of the overall stock market.
Depending on how old you are and how many years you have until your retirement, you will want to vary how much of your money you invest in stocks. When you are younger, with many years until retirement, you should put most, if not all, of your investments in stocks. Investing in stocks has a higher amount of risk, but with a long-term investment horizon, it provides higher returns. As you get closer to retirement age, you can start transferring some of your money into bonds or other investments that provide safer yet lower returns.
Average Index Fund Return
The average index fund return depends on which index the fund is tracking. The returns for most index funds closely match the returns of their underlying indices. For example, the Vanguard S&P 500 index fund (VOO) has a three-year cumulative return of 75.57%, compared with a 75.90% return of the S&P 500 index itself [as of 2022].
Which Index Funds Are Best to Get Started?
As mentioned above, you will want to choose your investment strategy (including index funds) based on your age and years until retirement. It can be a wise investment strategy to invest in a variety of different funds to spread out your risk and capture high performers in a variety of sectors. If you use a robo-advisor like Wealthfront or Betterment, they will automatically invest your money in a variety of low-cost index funds based on your overall risk profile.
Low-Cost Index Funds
It's important to look at the management fees and/or expense ratios of the index funds you're considering. While it's good to look at the historical returns, a high management fee can really eat up a lot of your returns. Most index funds have an expense ratio of less than 0.10%. If you see a fund with a much higher expense ratio, you'll want to reconsider whether it makes for a smart investment.
Other Investment Options
Of course, there are a wide variety of different places where you can put your money, both in and out of the stock market itself. Real estate, cryptocurrency, foreign currency, options, and precious metals are just a few places where you can invest. Many of these classes of investment are marketed heavily and promise the allure of amazing returns.
But unless you have a strong expertise in one of these areas and a reason to believe you know more than the average investor (and within a few years, proof that you can beat the market), it is prudent to be cautious. Very few people can beat the professionals who are experts in these areas. If you do decide you want to dabble in alternative investments, it's best to do it with just a small amount of your portfolio (no more than you'd be willing to completely lose) and to keep the rest invested in low-cost index funds. The same goes for trying to pick stocks yourself or trying to time the market. These are losing strategies for most.
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