Before I share the 6 Index Funds that I own in my portfolio, I want to go over my investing process and what role these index funds play in my portfolio. Below is the order of steps that I recommend and use in my accounts. I have found that since I started documenting my process and putting my thoughts on paper, my performance has greatly improved.
My Investing Process
- Maintain a checking account, where I keep at least 1-2 months of expenses in cash.
- Maintain a high-yield saving account where I keep an emergency fund. I want to spend a few minutes on this point because I think that this is crucial. When you are initially starting out investing, you should target at least 6 months of expenses in cash in this account. Gradually, you want to build this fund for about 12-18 months of cash if you are working and drawing a regular salary. If you are retired then this cash cushion should be larger. That means that if you are out of work, you can live on this cash for 12-18 months without having to sell your investments. Stock markets go through a cycle of recession, recovery, growth. A larger cash cushion will allow you to be calm when there is a recession and when you see your holdings fall 10, 20, 30 or even 50%. Your cash cushion will allow you to make smarter decisions. You will not be scared to sell out your investments at a loss and you will be able to ride out the recessions.
- Invest in our 401K plans to get the full employer match. All of these investments are in Index funds.
- Max out Health-Savings Account pre-tax. This is the best retirement account. All of these investments are in index funds.
- Out of the post-tax savings, I max out our Roth IRAs. All of these investments are in individual stocks.
- Next, I invest a fixed amount every month in a college-savings account (529 account) for my kids. All of these investments are in index funds.
- Any leftover money from that I don’t need in the next two years is transferred to my taxable brokerage account. In this account, I invest in individual stocks that are more growth-oriented. The largest growth in the past eight years has come from this account. However, I want to emphasize this point that I have been able to invest in individual stocks only because I have a strong foundation in our 401K accounts that is invested in Index funds. If I did not have the foundation of index funds, I would have not been able to let the winners in this account grow so much.
- Most of the investment blogs that I read are focused on investing in index funds only. I am not criticizing investing in index funds. In fact, I still invest in index funds every two weeks when I get my paycheck. The reason I started this blog is to spread awareness about investing in individual stocks in addition to investing in index funds.
I have talked to a few financial planners and found out that their focus is to invest your money in those securities which are likely to fall the least whereas I want to invest in securities which are likely to grow the most. If I had listened to the financial planners early in my investing career, I would have missed out on some massive winners because those stocks were considered overvalued at the time. If I want to invest in securities where I have the least chance of losing my money, then I am better off investing in an index fund at an expense ratio close to 0. Why should I pay someone to manage my money if that money is going to be invested in an index fund?
If you have been a diligent saver all your life and never invested in the stock market except your 401K accounts, you should consider investing in an IRA and/or a taxable brokerage account and start out with index funds. Just as maintaining a healthy diet and exercise together are important for your physical health, saving and investing together are important for your financial health. Make sure that you have saved for at least 6 months of expenses, and then consider the below-mentioned index funds for starting out.
The reason I recommend starting with index funds is because the individual stocks are too volatile and you may get scared out of the market and sell at the bottom if you have never invested before. If you are saving but not investing, you are not putting your money to work for you. Investing a small sum of money every month diligently can shave at least 10 years of work and can help you retire early. It certainly helped our family.
Mutual Funds/Index Funds/ETFs
One way of investing in the stock market is through mutual funds and exchange-traded funds (ETFs). Mutual funds are professionally managed portfolios of individual stocks or bonds. They pool money from the investing public and use that money to buy individual stocks and bonds.
Mutual funds are operated by professional money managers who make decisions about allocating that pool of money. There are actively-managed mutual funds where the fund manager actively decides where to allocate the money each month and there are passively-managed mutual funds (called index funds) where the investments track a market index such as S&P 500 Index or Russell 2000 Index etc.
There are thousands of mutual funds available (offered by companies such as Vanguard, Fidelity, Schwab etc.) and you can invest in them through a brokerage account. Each of these mutual funds typically charge an investment fee which is also called “expense ratio” which usually runs anywhere between 0.01% to up to 2% and sometimes more than that. In general, if you see an expense ratio above 2%, it is time to look somewhere else.
You would think that once you invest in any of these mutual funds, your money is working for you and earning at least market returns every year. However, that is not the case. Some of these mutual funds have a high expense ratio (anything more than 1% is high in my opinion). There are some mutual funds that are “front-loaded”. For example, if you invested $1,000 in a 5% load mutual fund, you would actually be invested $950 ($1,000-$50) and the remaining $50 will go to the company as a commission. You should avoid front-loaded mutual funds.
I heard this statement in a podcast and it sounded funny to me but I now believe it. Investing is probably the only field where a novice investor can do better than professionally trained investors. Don’t believe me! Consider the following list of mutual funds that have lost more than 20% per year for more than a decade: USPSX, USPIX, RYVTX, URPSX, UCPIX. I can keep going and add another 15-20 more mutual funds to this list but you get the point. Think about this for a minute. These are professional money managers, whose full-time job is to invest your money. All of these mutual funds have an expense ratio of more than or close to 2%. Not only are you paying them 2% to manage your money, but they are also losing your money at 20% per year or more for more than a decade.
For this reason, I do not like actively managed mutual funds. I strongly favor index funds over actively-managed mutual funds because they have exceptionally low costs. For example, FXAIX, a S&P 500 index fund that I invest in my wife’s 401K, has an expense ratio of 0.015% and has returned over 15% over the last decade. So, not only your expense ratio is a fraction of what you pay under an actively managed fund but you are also earning market returns. I call that a win-win scenario.
That is not to say that all actively managed mutual funds are bad. There are some actively managed mutual funds that have done better than index funds but they are few and far between. You just have to find them and actively monitor them. How do you monitor them? Look for management tenure (longer the better), Morningstar rankings, their portfolio, their past returns against the market. You will notice that most mutual funds will list a disclosure which says “Past performance is not a guarantee of future returns.” I find that funny because in my opinion, past performance over long periods of time (a decade at least) may very well be the only thing that is a good predictor of future earnings.
If you are employed and you have a 401(k) plan, it is most likely that your retirement contributions are invested in mutual funds. Most companies allow their employees to choose where they would like to invest. My employer does and if you asked me around 2012 that where my 401(k) money is being invested, I wouldn’t be able to tell you. However, when I started taking interest in my investments, I found out that they were invested in a lifecycle fund whose returns were lower than a S&P 500 Index fund. I find that ironic that I probably spent more time researching what TV I should buy than where my retirement money will be invested.
I did some research and chose some mutual funds and index funds and decided to invest in those. I am happy to say that those selections have been beating the market since then. If I had not done that, the difference in investment returns could have been tens of thousands of dollars. As you can see in this article, even a 1% difference can result in huge differences.
ETFs are very similar to mutual funds in that they also represent professionally managed baskets or portfolios of individual stocks or bonds. Moreover, both ETFs and mutual funds offer a wide variety of investment options and are overseen by professional portfolio managers. Following is a list of differences in ETFs and mutual funds:
- ETFs usually have low minimum investment requirements where some of the mutual funds have a minimum investment requirement of $1,000 or above. You can buy an ETF for the price of 1 share.
- ETFs trade during the market hours just like a stock and you have more control over the price of your trade whereas you can only buy or sell a mutual fund after the market closes. Regardless of what time of day you place your order to buy or sell a mutual fund, you will get the same price as everyone else who bought or sold that day.
- If you want to do a Systematic Investment Plan (SIP) where you automatically invest a fixed sum (dollar-cost averaging), you cannot do that with an ETF. With a mutual fund, you can set a SIP where your broker will automatically buy a fixed sum in your choice of mutual fund every month.
- ETFs usually allow you to choose more investments at the concentrated level. For example, if you want to invest in cloud companies, you can do that through an ETF such as WCLD. However, there is no mutual fund that offers investing at such a concentrated level.
For example, VOO and VFIAX are both Vanguard funds that invest in the S&P 500 index. VOO is an ETF whereas VFIAX is an index fund. They both invest in the same stocks, have very similar expense ratios and similar returns. As you can see ETFs and mutual funds are more similar than they are different and there is no reason that you have to choose one over the other. You can choose a mix of both.
Sometimes, you might be restricted in your choice. For example, in our 401(k) plans, our employers only allow mutual funds. We cannot invest in ETFs or individual stocks in that plan. If you are just starting out investing in the stock market, my recommendation is to start with a S&P 500 index fund. You would beat the returns generated by most of the professional money managers.
You don’t need to pay anyone to manage your money. One of the biggest drawbacks of the investment industry is that you won’t know how much you are paying someone to manage your money as you usually do not get an invoice from your money manager. Your investment fee is “conveniently deducted” from your investment accounts.
The best person to manage your money is you. Once you start with a S&P 500 index fund and get a little comfortable and understand the companies behind the index, you can venture out to ETFs and finally to individual stocks. In my personal portfolio, that’s what I did when I started with mutual funds in my 401(k) plan and later I started investing in individual stocks through Roth IRA and taxable brokerage accounts. I mentioned some of the individual stocks that I am invested in this article.
Following is a list of index funds that I am invested in our 401K plans, 529 plan and HSA as of Dec 31, 2020. I am just providing this list as a disclosure. You should not invest on the basis of what I or anyone else is doing. You should do your own research.
- FXAIX – Fidelity S&P 500 Index fund
- VITAX – Vanguard Information Technology Index Fund
- PRGTX – T. Rowe Price Global Technology Fund
- VTSAX – Vanguard Total Stock Market Index Fund
- VGTSX – Vanguard Total International Stock Index Fund
- TBCIX – T. Rowe Price Blue Chip Growth Fund
I also recorded a video going over these index funds and what percentage of my assets are invested in these index funds. You can buy that video for $20 at this link.
Do you invest in the stock market? What has been your experience? Do you want to start investing? What do you think after reading this article? I would love to hear from you. Feel free to write comments below and I will get back to you. Thanks for reading!