how to pick index funds

Here’s Why Picking Index Funds is Simple

Looking to learn how to pick index funds? You’ve come to the right place!

Last week we tried to hammer home the point that you will probably only lose in the long term by picking individual stocks. After all, if professional hedge fund managers can’t do it reliably, there’s no reason to think you can. Most people never assume they can perform brain surgery better than a neurosurgeon, but as soon as the topic changes to the stock market everyone seems to think they are Warren Buffet. Just because the barriers to entry are low, doesn’t mean being good is easy. Come on now, people! Let’s see how to pick index funds…

Since we don’t want to be picking individual stocks for our nest egg, how do we know which index funds we should be investing in?

Thankfully, there are only a few things that we really need to focus on when selecting our investments. However, none is really more important than expense ratios.

What is an expense ratio?

According to investment research firm Morningstar, an expense ratio is ‘the annual fee that all funds charge their shareholders. It expresses the percentage of assets deducted each fiscal year for fund expenses, management fees, administrative fees, operating costs, and all other asset-based costs incurred by the fund.’

The reason that the expense ratio is one of the most important factors is because every % that you have to pay in fees is a % that you will lose in returns. It’s as simple as that. You are giving your money away. To make matters worse, the fees will essentially compound over time so that you’ll miss out on an increasingly large part of potential investment returns.

For example, assume you have friends who are identical twins and that they each invested $10,000 in index funds today. Both of their index funds will have the same investment return since they are invested in the same stocks, but they have different expense ratios. Fund 1 has an expense ratio of 0.04%, while Fund 2 has an expense ratio of 2.5%. At the end of 15 years Fund 1 will be worth $20,671, while Fund 2 will only be worth $14,483. That “measly” difference of 2.46% in expense ratio ate up nearly 60% of the potential investment profit. What a shame indeed!

We LOVE this example because it also highlights the difference in fees when picking individual stocks since the commissions you’ll pay to invest in those stocks or actively managed funds can go up to 3%.

As that example highlights, learning how to pick index funds is easier than it seems. See the example below for those of you who are visual learners like us. how to pick index funds_The Finance Twins_Expense Ratios

In case that example isn’t clear, you’d have to consistently beat the market by ~2.5% every SINGLE year in order to make up for the high fees. Seems kind of ridiculous, right?

Besides expense ratios, what else matters when deciding how to pick index funds? Diversification!

If you read our last post on why you shouldn’t pick stocks, you’ll remember the importance of buying a total market or S&P 500 index fund.

As a reminder, an index fund is a group of stocks that you can buy as a bundle. Owning a broad group of stocks will protect you from some of the risk of picking the wrong stocks. In an index fund, some stocks will go up and some will go down. However, as John Bogle, founder of Vanguard, has pointed out in his books, the stock market as a whole has always gone up over the long term. This means that if your portfolio (investments) reflects the broader stock market, your investment will grow over a long period of time even as some individual stocks go down.

Which specific index funds have low fees and represent the broader market?

To begin, we want to queue the drumroll while we remind everyone that we are not investment advisors or broker dealers. What that means is that you shouldn’t rely on our information to make your investment decisions.

Below is a list of the funds we considered when we were deciding how to invest our own money. And it’s a good starting point for you. We aren’t advertising these securities, recommending them to you, and we certainly are NOT being paid in any way to list them or mention them to you.

This is just showing you what we felt were great options for our OWN investment portfolios, because they represent the broader stock market and they have low expense ratios. These are the two factors we feel are the most important when selecting a long-term investment strategy.

Generally, the funds that correspond to your brokerage are the ones that will have the lowest fees for you. So, if you have a Fidelity account, you’ll probably mostly look at their own Fidelity index funds.

For new investors, we love Vanguard’s long and storied history of low fee index funds. While Charles Schwab or other brokerages may raise their fees from time to time, Vanguard wrote the book on low fee index funds and they’ve consistently kept them that way.

Now that you know how to pick index funds, let’s see what some of your options are.

Short List of Index Funds with Low Expense Ratios

Vanguard Stock Index Funds

  • Target date funds: Min: $1,000; Exp Ratio: 0.15% (includes stock and bond index funds)
  • Total Stock Market Index Fund Investor Shares: Min: $3,000; Exp Ratio: 0.15% (VTSMX)
  • Total Stock Market Index Fund Admiral Shares: Min: $10,000; Exp Ratio: 0.04% (VTSAX)

Vanguard Bond Index Funds

  • Total Bond Market Index Fund Investor Shares: Min: $3,000; Exp Ratio: 0.15% (VBMFX)
  • Total Bond Market Index Fund Admiral Shares: Min: $10,000; Exp Ratio: 0.05% (VBTLX)

Fidelity Stock Index Funds

  • Target date funds: Min: $2,500; Exp Ratio: 0.15% (includes stock and bond index funds)
  • Total Market Index Fund – Investor Class: Min: $2,500; Exp Ratio: 0.09% (FSTMX)
  • Total Market Index Fund – Premium Class: Min: $10,000; Exp Ratio: 0.035% (FSTVX)

Fidelity Bond Index Funds

  • U.S. Bond Index Fund – Investor Class: Min: $2,500; Exp Ratio: 0.14% (FBIDX)
  • U.S. Bond Index Fund – Premium Class: Min: $10,000; Exp Ratio: 0.045% (FSITX)

Charles Schwab Stock Index Funds

  • Target date funds: Min: $1.00; Exp Ratio: 0.08% (includes stock and bond index funds)
  • Total Stock Market Index: Min: $1.00; Exp Ratio: 0.03% (SWTSX)

Charles Schwab Bond Index Funds

U.S. Aggregate Bond Index Fund: Min: $1.00; Exp Ratio: 0.04% (SWAGX)

If you are curious about how to think about the split between stocks and bonds or even what a target date fund is, make sure to subscribe to our newsletter to be notified when our next post goes live!

Do you feel confident that you know how to pick index funds?

Sources:

[1] http://www.morningstar.com/InvGlossary/expense_ratio.aspx

[2] https://www.fidelity.com/fund-screener/evaluator.shtml#!&mgdBy=F&ntf=Y&idxFd=Y&tab=mf&ft=DSTK_all&mininv=LS5000&exp=1

[3] https://investor.vanguard.com/mutual-funds/list#/mutual-funds/asset-class/month-end-returns

[4] https://www.schwab.com/public/schwab/investing/investment_help/investment_research/mutual_fund_research/mutual_funds.html?&&path=%2FProspect%2FResearch%2Fmutualfunds%2Foverview%2Fschwabfunds.asp%3Fsymbol%3D%26type%3Dindexfunds

6 thoughts to “Here’s Why Picking Index Funds is Simple”

  1. Hi Guys!

    Thanks for the advice. I have a question regarding your index funds listed. From a cursory glance it seems that the Charles Schwab index funds would be great for new investors due to 1) your stated importance in low expense ratios at 0.03% and 2) the minimum investment at $1.00.

    You did state that Charles Schwab is more likely to raise fees compared to Vanguard but it seems like you could invest smaller amounts at a substantially reduced expense ratio using Charles Schwab compared to the other index funds. Could you let me know if Vanguard or Fidelity traditionally have a higher return than Charles Schwab to make up the difference in expense ratios? Thanks so much!

    Take Care,

    1. Hey Thane– Thanks for the question. What you’re saying makes a ton of sense. You’re 100% correct about Charles Schwab having the lowest minimums and very low expense ratios. The difference in returns when investing in total stock market index funds really comes down to the expense ratios.

      Though Vanguard was the pioneer of the low-cost index fund, the other players are trying to get some of that market share by offering very competitive expense ratios. For this reason, they will likely also try to keep the expense ratios low. The key is to buy and hold your investments for the long haul. The shorter you hold an investment the higher the tax burden. By buying and holding for many years (5+) you will be minimizing the total amount lost to fees and taxes (however, if you’re investing in a Roth IRA, you don’t pay capital gains taxes since you’re putting in after-tax dollars).

    1. Hey Mike. It all depends on the types of investments your 401K provider makes available to you. Some will give access to the lowest fee Vanguard funds, while others won’t. You’ll just have to call your rep (or login and check online) to find out! Good luck!

  2. This is great information for my young adult children. As a 70 y/o retiree though, I think I am better served by a mixed portfolio of stocks, bonds and mutual funds. Agree?
    Thanks

    1. Hi Harry, thanks for your comment. You definitely want to keep a diversified portfolio. Common wisdom says that as you age you should slowly add an increasing amount of bonds to your portfolio. Our article on asset allocation does a good job of explaining the types of investments that we love and how the allocation can change over time.

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