Why You Need To Start Investing Now: How (And Why) To Start With Index Funds
Today we have a great guest post from Just Starting Investing. The post covers why you need to start investing now, how to get started, the pros and cons of index funds and so much more. One of the most effective smart money moves you can make is to start investing as early as you can in your financial journey. The powers of compound interest and benefit of building that habit will help you reap the rewards. JSI is here to help show you how (and why) you can get started with index funds.
Every day you wait to start investing is less money in your future pocket.
The mission of my site, Just Start Investing, is to make investing easy. Investing can be really simple – it’s only hard if you choose to make it that way. My goal is to keep investing easy so that anyone and everyone can get started and maximize their money.
Starting now is important for reasons we’ll get to in just a minute. First, a quick primer on index investing, which is the easiest way to get started.
What Is Index Investing?
Index investing is the easiest (and arguably the best) investing strategy to implement on your own. It involves investing in index funds (obviously) with the goal of matching total market returns.
Index funds are a combination of indexes and mutual funds. It combines the simplicity of matching an index (like the S&P 500) with the diversification benefits of buying a mutual fund.
Though, instead of relying on a money manager to pick stocks that they think will do well, an index fund simply matches a broad index. No stock picking. No gambling.
For example, if Amazon makes up 3% of the S&P 500, then 3% of the funds go into Amazon (with an S&P 500 index fund). A money manager does not get to put 10% in Amazon because he or she has a hunch. The index fund mirrors the index – no exceptions.
The Benefits (And Downfalls) Of Index Investing
There many pros and few cons to index investing. For new investors, the pros of index investing usually greatly outweigh the cons.
Index Investing Pros
#1 Pro of Index Investing: It’s a Simple Strategy
Index investing is both easy to start and hard to mess up.
Getting started is easy because you only need to buy one (or a couple) funds. Rather than researching stocks and buying a whole bunch of them to get proper diversification. Or trying to find a reliable financial advisor who has your best interest in mind while helping you pick stocks and investments.
Plus, index investing is very hard to mess up. You don’t need to worry about if one of your stocks crashed or if you are holding the right mix of investments. You simply buy one (or a few) index funds, and hold them for the long term.
Of course, you should still be rebalancing your assets as needed, but it’s a lot easier to do that with a couple funds than with 20+ stocks!
#2 Pro of Index Investing: Diversification
Diversification is a fundamental risk management strategy for investing. It involves owning multiple investments to limit your risk of one investment taking a tumble and sending your whole portfolio downwards.
As hinted at earlier, investing in index funds gives you broad diversification with just one purchase.
One index fund can hold hundreds of individual stocks and give you the diversification of those hundreds of stocks without the complexity of actually having to own each one.
Technically, you do own each one, but it’s a lot simpler to manage through one index fund.
#3 Pro of Index Investing: Low Costs
Index investing is extremely affordable and a great value.
Compared to mutual funds, index funds are usually a fraction of the cost. Some great index funds have expense ratios from 0.02%-0.05%. That means you pay $2-$5 for every $10,000 invested.
Some mutual funds can run you 0.25%-1% in expense ratios, if not higher! That’s $25-$100 for every $10,000 invested.
Compared to stocks, index funds provide a great value. Sure, technically, buying hundreds of stocks to match an index fund through an app like Robinhood is cheaper (they charge $0 transaction costs). Though, there are still a couple issues.
For one, you might end up paying a ton of money in spreads (the difference between the ask and bid price) over the long run.
Second, you need to have a lot of capital to do this efficiently. Think about stocks like Amazon that cost well over $1,000. If Amazon is going to make up only 1-2% of your portfolio, you have to have enough money (likely over $100,000) to properly allocate funds to that stock (and others).
Last, the time you spend managing this portfolio can be daunting. You have to pay close attention and rebalance countless stocks as needed. Your time likely better spent elsewhere.
#4 Pro of Index Investing: History of Success
Last but not least, index funds have a proven track record of success.
The S&P 500 has historically returned +7% annually. $10,000 invested today would be worth $138,426 in 40 years at that rate (also assuming a 0.03% expense ratio).
Compare that to an actively managed mutual fund which not only has to beat the +7% benchmark, but has to beat it enough to cover its annual fees (which can be 0.25%-1%, or higher).
And if the actively managed fund can’t beat the benchmark and grows at the same +7% rate (with the 1% fee), it only grows to $97,035 over a 40 year period. That’s over $40,000 less than the index fund!
Index Investing Cons
There are a few downsides to index investing as well.
#1 Con of Index Investing: Tax Loss Harvesting
With index investing, you lose most of your ability to tax loss harvest.
Of course, you can still sell your fund in a down year and re-purchase a similar fund. Though, in a year where you fund does well, you lose that ability. Not sure we should we be complaining about this, but some do.
If you owned a basket of say, 50 stocks, in any given year you could expect a handful of them to be down and a handful of them to be up. Even in a tremendously positive year, surely a couple would be down.
This is the advantage of owning the individual stocks, because you can still sell the losers within your portfolio (and repurchase similar, but not identical stocks). So you can tax loss harvest even during a good year. If you own an index fund, you own the whole fund, and cannot pick and choose stocks within it to tax loss harvest. You can only harvest the full fund and can only do it during bad years.
#2 Con of Index Investing: Flexibility
There are many arguments about if market cap weighting is better equal cap weighting, or if small cap is better than large cap, or if tech stocks are better than industrials, and so on.
With index investing, you can still own multiple funds to diversify across borders and market cap sizes, but you lose some of the customizability that you get with individual stocks.
Honestly, not sure this is a bad thing. Owning the whole market is the point of index investing and has worked out pretty well for people so far. Nevertheless, it’s worth calling out.
Why You Cannot Afford To Wait: Start Investing Now
So, index investing is good, but starting to index invest now is even better.
Index investing makes getting started very easy. And starting now is important because every day you wait means less money in your future pocket.
I won’t go too far into the weeds for those of you who are familiar… but let’s lay out a quick example.
Compound Interest Example
Say the market returns 10% every year (using even numbers to make the math easy). If you invest $1,000 today, one year from now you will have $1,100. That’s $100 (10%) in growth!
The beauty is, next year, you will see $110 in growth, not $100. You are growing on your new, larger base of $1,100. So you get an extra $10 with no extra investment.
Plus, if you saved and added more money to your investments, then you grow on that even larger base!
As you continue to accumulate wealth and save, compounding returns works as a snowball effect. Earning you more and more as your base of money grows.
What Waiting 5 Years To Start Investing Costs You
Let’s see how this plays out in a more realistic example.
Say you have $10,000 right now, ready to invest (pretty good place to be, huh). Though, you’re unsure of what to do with the cash. Instead of investing right away, you put it in a savings account (or under your mattress).
Then, 5 years later, you finally work up the courage to invest the $10,000. And you keep it invested for 35 years until retirement.
Not bad right? You probably netted some pretty solid gains (investing for 35 years is a long time)!
By holding the $10,000 for 5 years, you missed out on 4x that initial investment.
Your funds only grow to $98,834. While the extra 5 years (investing for 40 years total) grew the $10,000 to $138,426.
That’s the magic of 5 years of compounding returns at the end of your investing life.
What Waiting 1 Year To Start Investing Costs You
Alright, maybe you think 5 years is extreme. Maybe you’ve only been procrastinating 1 year.
Surely, 1 year does not matter…
Waiting just 1 year can cost you almost your entire initial investment over the long run.
You’re giving up nearly $10,000 because you decided to hold onto your $10,000 for only 1 extra year. The cost of waiting is huge!
How To Choose An Index Fund And Start Investing Now
You cannot afford to wait to start investing. Getting started is easy, and every year you wait is costing you!
Choosing an index fund is simple and anyone can do it on their own. Here are a couple things to keep in mind:
- Look to mirror an established index
- Seek out low expense ratios and other fees
- Buy through a low cost broker, like Charles Schwab or Vanguard (Canadians can take the DIY approach with Questrade or robo-advisor route with Wealthsimple)
Get some more help on choosing an index fund or ETF here.
And remember, the beauty of index investing is that you can get started with limited capital! So there is nothing holding you back.
About the Author of Why You Need To Start Investing Now:
Just Start Investing is a personal finance website that makes investing easy. Learn the simple strategies to start investing today, as well as ways to optimize your credit cards, banking and budget.