How to Invest Using Only Index Funds

Regular Free Money Finance readers know that I'm a big fan of index fund investing. So when I found this piece from Kiplinger's that details how to invest using only index funds, I knew I had to share it here.

Much of the piece details the advantages of index funds -- the same ones I noted in Why I Like Index Funds, Part 3: they deliver solid returns, have low costs, are easy to manage, are diversified, and are recommended by even the best-known investors. Some of their thoughts bear repeating. For instance, on the solid returns posted by index funds:

The numbers bear me out. Roughly two-thirds of actively managed funds fail to beat simple index funds.

They take little time to manage:

They aim merely to mirror a market barometer, such as Standard & Poor's 500-stock index or the Wilshire 5000 or the Russell 2000. Consequently, they don't require any monitoring. It doesn't matter much whether the manager leaves or stays put. Index funds have such an easy job that they tend to achieve their goals no matter who's in charge.

They have low costs (which lead to great returns):

The best index funds -- those provided, most notably, by Vanguard and Fidelity -- accomplish their humble task with aplomb while charging investors a pittance. Expenses range from less than 0.1% of assets annually to a still-modest 0.35% annually. By contrast, actively managed funds typically charge more than 1% for annual expenses (that doesn't include sales commissions, which many funds charge). Index funds derive their advantage almost entirely from low costs. If you come upon a high-fee index fund, avoid it. A cheaper fund will always perform better (assuming you're comparing funds that mimic the same index).

Then it gets to what I consider to be the heart of this piece -- it recommends how you can invest using only three index funds. Their thoughts:

Want to invest with a minimum of fuss and a maximum of simply? All it requires are three index funds. You can turn to either Vanguard (www.vanguard.com 800-635-1511) or Fidelity (www.fidelity.com; 800-544-6666). I prefer Vanguard because the firm is organized in such a way to suggest that its prices will likely always remain rock-bottom.

Put three-quarters of your stock money in Vanguard Total Stock Market Index (VTSMX), which covers the entire U.S. stock market. Stocks of large companies get the lion's share of your money, but midsize and small companies are also well represented. Invest the remaining fourth in Vanguard Total International Stock Index (VGTSX). It gives you the rest of the world.

For your fixed-income money, use Vanguard Total Bond Market Index (VBMFX). If you're investing in a taxable account, substitute an actively managed bond fund, Vanguard Intermediate-Term Tax Exempt (VWITX). It invests in high-quality municipal bonds.

He then ends with this bit of advice:

There's just one key ingredient that I can't supply you: fortitude. For any investment plan to work, you need patience. You need to stick with the program -- especially when it doesn't seem to be working. For instance, in the 2000-02 bear market, broad-based index funds lost nearly half their value.

Yep. In order to be successful with index funds all you need to do is keep investing in them -- year after year, no matter what the market does. Even if it drops like a rock, keep buying. (In fact, I often make EXTRA buys right after a big market drop -- it allows me to get the funds at a much better price than what they were a few days earlier.) ;-)

I own the Vanguard Total Stock Market Index fund and it's the main fund I'm putting money in right now. (Most of my money is in the S&P 500 Index -- I started investing in it years ago), but I don't have any of the other two funds. I'll check them out and consider how I need to adjust my investments based on the advice in this column. At this point, I have a good amount of capital gains built up in many investments, so making any change is somewhat like turning an oceanliner -- it doesn't happen very quickly.

Comments

[NCN]

If I plan to make one purchase per year in each of the following accounts: 2 ESA's and 2 Roth IRA's, would it be cheaper to use ETF's instead of Mutual Funds. In other words, I will contribute $2000 to my ESA for 2007 and I can purchase a mutual fund that tracks the S&P 500 OR an ETF that tracks the S&P... which would be better? I plan to "buy and hold" for 5 to 15 years...
Thanks,
NCN

[FMF]

NCN --

It depends on the cost of each index fund and ETF (believe it or not, they have different costs even from one index fund to another.) Ask the company you're using to invest (like Vanguard) to tell you the expense ratios.

That said, if you're investing a big lump sum, ETF will usually be the best option. However, what I do when I save a big amount is to put it into the account in cash and then dollar-cost-average it throughout a period of time. In this case, I use index funds since I'm buying on a frequent (monthly) basis.

Hope this helps.

[tinyhands]

There's nothing particularly wrong with the advice in that article, but I would caution that one-size-fits-all investing isn't necessarily best. (As much as I hate using the word best- there is rarely such a thing.)

The conventional wisdom is that younger investors can afford to assume more risk by selecting targeted indexes such as small/mid-caps or emerging markets. Older investors should be transitioning to lower risk and/or fixed income.

[Used vans girl]

why do you say older investors should be transitioning to lower risk and/or fixed income? Is this because older investors lack the time commitment or should be taking less risks because they are old?

[rwh]

Older people have less time to make up large losses that can occur, such as 2000-2002. Older people also tend to be retired, so they don't have income from a job.

I think the investment advice in this article is quite good.

[1WineDude]

Great article - I've had investments all over the place the last 10 years, and for the last year or so (excluding 401K) I've been stocking away $300/month into the Vanguard Prime Money Market, and the Vanguard Index 500 fund.

Just curious about 2 things:
1) Do you recommend the Vanguard Total Stock Market Index fund over the 500 Index fund?

2) Any update on whether of not you picked up the International Stock Index and/or Total Bond Market funds? If so, any comments on them so far?

Cheers!