Frugal Millionaires Love Index Funds

Here's an excerpt from the book The Frugal Millionaires: 70 millionaires anonymously share their ideas about money to help each other and you. Today we're seeing what the millionaires have to say about index funds. You all already know that I love index funds (I'm almost exclusively in them now) and it seems frugal millionaires do too. Makes sense, since I'm one of them.

FYI, these are some representative tips from The Frugal Millionaires. There are over 800 tips in the book. The frugal millionaires are only referenced by their initials. The author signed a confidentiality agreement that the millionaires' identities would never be disclosed in exchange for them saying whatever they wanted. If they chose not to have their initials used they were given the initials AFM which is an acronym for Anonymous Frugal Millionaire.

Here's the excerpt -- they start by defining what an index fund is (in case readers don't know):

DEFINITION: An index fund is a collective investment scenario (usually a mutual fund or an exchange-traded fund) that aims to replicate the movements of an index of a specific financial market. An index fund is created by trying to hold all of the securities in the index, in the same proportions as the index. Many index funds rely on a computer model with little or no human input in the decision as to which securities to purchase and is therefore a form of passive management. The lack of active management (stock picking and market timing) usually gives the advantage of lower fees and lower taxes in taxable accounts. (SOURCE: Fidelity Investments, with edits)

EXAMPLE: An S&P 500 Index Fund takes all the stocks in the S&P 500 and buys enough shares in each company to represent the dollar value of that each company represents as a percentage of that market. So, if the Acme Company represented 2% of the value of all the S&P 500 companies combined then an S&P 500 Index Fund would have 2% of its dollar value in Acme stock.

Since markets generally (meaning almost always) outperform managed funds, and have significantly lower management fees than managed funds, they are a better investment alternative. This is why the frugal millionaires like them as part of their portfolios. Their success/failure is also easier to track. If the S&P 500 went up 1.5% over a one week period so did your S&P 500 Index Fund. The same would be true if it went down.

Index funds are part of a balanced stress-free portfolio. You can use them to buy an overall “market” position. But you should also be considering other options with a portion of your portfolio in more risky investments (only to the degree that you can afford to lose that money) and some conservative options as well. It will all depend on your personal risk profile.

AFM – Index Funds are lower cost and perform better than almost all other similar funds, plus the managed funds have high fees that typically eat into your earnings. Over time that could ruin you. Managed (not indexed) funds that do well often have money rush in and then under perform while new investments are made.

AFM – In nearly every investor letter that Warren Buffett writes he talks about putting your money in Index Funds. Who can argue with that? If you must buy a mutual fund, never buy a “loaded” one (just say no to upfront commissions!).

AFM – Buy Index Funds since personal or even broker stock picking falls behind Vanguard or Fidelity Index Funds about 80% of the time. Don’t sell them.

Comments

[Strick]

I love index funds, because they do better than most investments in securities due to the lower fees and lower turnover.

That said, I'm a little surprised there are still quotes like this out there that seem to downplay the risk:

"Index funds are part of a balanced stress-free portfolio. You can use them to buy an overall “market” position. But you should also be considering other options with a portion of your portfolio in more risky investments (only to the degree that you can afford to lose that money)..."

I think we've learned there is nothing stress-free about a S&P500 fund nor is that the place where you can put money you can't "afford to lose". Folks who thought an index fund was the key to safety learned dearly with the Nasdaq100 in 2001, and seems like a lesson being retaught with the S&P500 and "total market" indexes now.

[FrugalWorld]

Great tip, and presented in a way that even I could grasp it right away. :-) Thanks!

[Paul Morales]

Thanks, Great tips. I didn't know what an index fund was ;)