Declan Molony is a business administration senior and Mustang News opinion columnist. The views expressed do not necessarily reflect those of Mustang News.
Among the many shortcomings of the American education system is the knowledge on how to invest. Only 55% of Americans are invested in the stock market and just because they are, it doesn’t mean they completely understand the investment process. This article will explain on a basic level the only thing you need to know to be a successful investor, should you choose to take the risk.
Notice I said ‘should you choose to take the risk.’ No investment is without risk. But the following investment option is, in my opinion, one of the least risky and most rewarding options available. They’re called: low-cost index funds. Allow me to break down what that means.
Index Funds. Let’s say you want to invest all your money in Tesla. You think electric cars are the future and are willing to bet that the price of Tesla stock will increase over time. Your money is entirely dependent on the performance of a single company. If Tesla does well, that’s great. If Tesla does just okay or starts to decline, then you may end up losing money. What if instead of choosing to invest in individual companies and hoping they do well, you could invest in the entire U.S. stock market all at once? Well, you can. It’s called an index fund.
Index funds cover virtually all of the available stocks in the U.S. One index fund called VTSAX (Vanguard Total Stock Market) covers 3,634 different companies. So if you invest in an index fund and Tesla’s stock decreases, the performance of three THOUSAND other stocks will average out your investment.
Low-Cost. What does it mean for an index fund to be low-cost? To understand this, let’s first explain what happens when you invest your money with a stockbroker. A stockbroker manages all your investments and gets paid based on a commission that’s usually around 1% to 2% of a client’s assets. Let’s look at an example.
Stockbroker Example. Let’s say you have $100,000 in an account with a brokerage firm that charges a 1% annual fee. Your investments do well this year and earn 7%. So at the end of the year you have $107,000 in your account (100,000 * 1.07), but you have to pay a 1% fee which results in you having $105,930 in your account at the end of the year (107,000 * 0.99). So in total, you made $5,930 in a single year, and the stockbroker made $1,070 (107,000 – 105,930). How does this compare to a low-cost index fund?
Low-Cost Index Fund Example. The index fund VTSAX I mentioned before, managed by its parent company Vanguard, charges a 0.04% annual fee. If you’re not immediately shocked by how small that is, let’s see how that would change the math from the previous example. So after making 7% on your $100,000 you’re charged 0.04% which results in you having $106,957 (107,000 * .9996). You made $6,957 and Vanguard made $43.
|Summary of Stockbroker v.s. Index Fund Investment|
|Stockbroker||Vanguard (index fund)|
|Your Annual Takeaway||$105,930||$106,957|
|The Company’s Takeaway||$1,070||$43|
If you choose to invest with a stockbroker over an index fund, you’ll lose $1,027 (1,070 – 43). However, that difference doesn’t account for compound interest (how much money grows over time). The stockbroker will take that $1,027 and invest it for themselves, rather than for you. Over a 40 year investment period with an average return of 7%, that money will grow to be $15,378 (1,027 * (1.0740)). Because of your decision to invest with a stockbroker, you essentially lost $15,378 that should have been your money. But it gets worse! For every year you continue to invest with a stockbroker over a low-cost index fund, you keep losing money which also grows due to compound interest. Over a lifetime, it could result in you losing tens, maybe even hundreds of thousands of dollars.
So now you understand what a low-cost index fund is. It has a relatively low fee compared to what stockbrokers charge, and your investment does as well as the whole U.S. stock market performs. There’s one more huge advantage of index funds.
Part of the reason you pay stock brokerage and private equity firms such a high fee (1% to 2%) is because they’re moving your money around in what’s called an active fund — trying to pick the ‘winners’ of the stock market throughout the year. Comparatively, your money in an index fund is stationary and will always do as well as the whole market.
Here’s the most important difference: every year 80% of active funds (managed by stockbrokers) fail to outperform index funds! And over a 30-year period, only 0.6% of active funds outperform index funds!!! So why would someone invest with a brokerage company rather than in index funds? I’d like to think the reason is because they’ve never heard of index funds…
Takeaway. Should you choose to invest in an index fund rather than with traditional stock brokerage firms, you’ll make MORE money on average, and pay LESS in fees. It seems like a no-brainer.
But remember: no investment is without risk. The following is a graph of VTSAX, the index fund I’ve mentioned several times, over the last 20 years (years are on the x-axis).
There are two major historical events that you can pretty easily identify on this graph: the financial crash of 2008, and the recession brought on by the arrival of COVID-19 in March 2020. But guess what? The market recovered. Let’s say you started investing with VTSAX in 2008 when things were going great — then the economy tanks. As you can see, your investments would have recovered in about 2.5 years. Despite these two major events, VTSAX has still accumulated an average annual return of 10.23% over the last 15 years. In the long-run, index funds perform spectacularly.
If this topic is interesting to you and want to learn more about investing, I highly recommend checking out the author J.L. Collins. He spoke at a Talks with Google event where he discussed how to build wealth, manage debt effectively, and how the stock market really works among other topics.
- His extremely popular book, The Simple Path to Wealth, is all the things he wished he could have told his daughter while she was growing up about important financial decisions in life.
- He has a blog that includes the greatest hits of his financial wisdom.
Investing is Long-Term. Most people lose money in the stock market because they think they can ‘time’ the market or pick ‘winning’ stocks. People are easily scared by a sudden dip in the economy, or excited by the thrill of a company suddenly doing very well. But if you hold onto your investments and shoot for the long-term, you can achieve financial success.