Thinking of investing can be overwhelming.
How much money do I need to start investing? How do I get started? Will I lose my money?
Let’s forget all the complexities of investing in today’s world for a second and imagine what investing would look like in a perfect world.
In a perfect world, I would stick my money in a Magic Box and there would be more money in it every time I checked.
[Okay, okay, yes, I guess in a perfect world money wouldn’t even be a thing and there would be world peace, yadda, yadda]
What makes the Magic Box so perfect?
- It’s simple –– I just put the money in my Magic Box
- It’s free –– no financial “advisor” is taking a cut of my money, no one is charging me fees
- I’m guaranteed returns –– every time I open the box, there’s more money
As it turns out, we don’t live in a perfect world.
So the question then becomes:
How can we get as close as possible to the Magic Box in today’s world?
Taking a walk through the world of stocks
A stock is a much, much crappier version of the Magic Box.
The problem with buying stock in a company is that it’s essentially a gamble.
Not a gamble in the sense of Vegas style blow-on-the-dice-and-hope-I-roll-a-7 gamble, but a gamble in the sense that you are betting that a SPECIFIC company will grow and make the stock you bought be worth much more in the future.
The trouble is that CONSISTENTLY predicting which stocks are studs and which are duds is almost impossible (unless your name is Warren Buffet).
Let’s imagine Jim (who is Jim? you ask. Jim is you, Jim is me, Jim is all of us) wakes up on August 23, 2004, makes a cup of coffee, and sits down to read the Wall Street Journal as he does every morning.
As he’s reading the paper, he comes across a little snippet announcing Google stock is now open for sale to the public.
Jim is already a fan of their search engine and the more he reads about Google, the more intrigued he becomes.
At work, he discovers Gmail, and is so overcome by amazement that he blurts out “Doggone it! This Google is the future!”
[Yes, Jim makes liberal use of “Doggone it!” when excited]
People stare at Jim weirdly and Marge asks him to pipe down (Marge has had it out for Jim ever since he asked her to please stop eating week-old salmon in the desk area), but Jim is too excited to care.
That same night, Jim takes his life savings, $10,000 earned through his blood, sweat, and tears, and invests it in Google stock.
On August 23, 2004, each share of Google stock is selling for $50, so Jim’s $10,000 gets him 200 shares of Google.
Fast forward to today, those 200 shares of Google are now worth over $231,000.
While this version of Jim celebrates his good fortune, in an alternate reality, on that fateful morning, Jim, rather than coming across Google’s announcement, comes across a little snippet announcing Motive, Inc. shares are now for sale.
[If at this point you’re thinking, “WTF is Motive, Inc?”, then you might have an idea of how this will end.]
Jim goes to work, checks out Motive, Inc., blurts out excitedly, people stare at him, Marge tells him to pipe down, Jim invests his savings in Motive, Inc., et cetera, et cetera.
We’ve seen this before.
Fast forward to today, however, and poor Jim is crying at his desk as Marge’s noxious fumes invade his cubicle and viciously attack his nostrils.
Well, Motive, Inc. was no Google.
In fact, in 2008 they got bought by another company at a clearance price and turned Jim’s original $10,000 into $2,000.
Jim’s two alternate realities show that while stocks have the potential to be our Magic Box, they also carry massive risk.
So if picking stocks doesn’t work, what can we do?
How can we take advantage of the growth of the stock market without risking all we got?
Enter index funds.
It’s a bird, it’s a plane, no… it’s index funds!
A stock index fund is a bundle of stocks that follows some rules for determining which stocks will be added to the bundle and in what quantity.
A typical rule for an index fund is that it track an index.
An index is a measure of change in a specific group of things over time.
For example, the Consumer Price Index (CPI) measures the change in price of typical consumer goods and services (food, gasoline, housing, clothing, etc).
When the price of food and gasoline increases, then the CPI increases, and vice versa.
So then what does it mean to track an index?
To track an index simply means that you behave as the index does.
Let’s look at VTSAX (Vanguard Total Stock Market Index Fund), an index fund offered by Vanguard (Jack Bogle, Vanguard’s founder, is the one who created the first index fund available for the public).
VTSAX tracks the CRSP US Total Market Index (I’ll abbreviate this to CRSP USTMI from now on).
Much like the CPI tracks consumer goods and services, the CRSP USTMI tracks over 3,500 companies who sell stock in a US stock market. Basically, if you can buy stock in it in a US stock market, it’s in the CRSP.
When the price of stocks of companies tracked by the CRSP USTMI increases, then the CRSP USTMI increases, and vice versa.
The composition of the index fund mirrors that of the index it tracks.
All VTSAX does is collect money from people (this index fund currently manages $698 billion…yes, with a B) and then turns around and uses that money to buy shares of stock in the companies and the quantities indicated by the CRSP USTMI.
Amazon makes up about 2% of the total value of the CRSP USTMI, so about 2% of the $698 billion goes towards buying Amazon stock.
Google makes up another 2% of the total value of the CRSP USTMI, so another 2% of the $698 billion goes towards buying Google stock.
If you go here, you can see every single company VTSAX owns shares in (3,602 in total) and how many shares of each company it owns.
So now you’re thinking, index funds sound great, what’s the catch?
Catch #1: Index funds are essentially a compromise
Index funds are designed to address the impossibility of knowing in advance if a company is a Google or a Motive, Inc.
Index funds like VTSAX get around the selection problem by saying, “Screw it. We’re not going to pick at all. We’re just going to buy stocks in every company possible and we’ll do as well as the market does.”
By investing in index funds, you don’t get the exponential growth you would have gotten if you had bet on Google, but you avoid the severe loss you would have faced if you bet on Motive, Inc.
This approach works well because, historically, the value of the market as a whole has increased over time.
Innovations, such as cars and planes and the Internet, have led to increased efficiency and wealth, and this is reflected in the growth of the stock market.
Catch #2: You’re still buying stocks so you still face risk
During 2008, the first year of the Great Recession, the stock market lost 37% of it’s value.
That’s right, the “growth” of the stock market in 2008 was… -37%.
Since index funds track the market, and so mirror its performance, they fared just as “well”.
If you had invested $10,000 in VTSAX on May of 2008, by February of 2009 your investment would have been worth about $5,300.
You would have “lost” half of your investment in less than a year. A scary sight.
However, by the end of 2009, you would have been back over $8,000.
And by May of 2018, your $10,000 investment would be worth just over $24,000, over 2 times what it was 10 years ago.
Compare this scenario to the one in which Jim lost his money when he bought Motive, Inc. stock.
When Jim bought Motive, Inc. stock he lost his money permanently because the stock never recovered. He made a wrong bet and, poof, his money was gone.
When you own index funds during a depression, however, you’re “losing” your money temporarily. Once the economy bounces back, you will regain all that you lost.
As awful as it sounds, a depression can even be an opportunity to buy stocks on the cheap. A clearance sale of sorts.
Though in the short term depressions and recessions can greatly affect your returns, if you take a long-term view and don’t panic, index funds allow you to capitalize on the growth of the stock market with reduced risk.
Catch #3: Index funds aren’t free
The companies who manage the index funds charge you for the convenience they offer.
If you use a low cost index fund, however, this cost becomes almost negligible.
VTSAX, for example, charges .04% ($4 for every $10,000 invested).
FSTVX (Fidelity Total Market Index Fund), another low cost option, charges .035%.
Buying stocks, on the other hand, can cost you up to $6 per purchase, which can quickly eat into the money you have available for investing.
Catch #4: Index funds generally have a minimum
The minimum to start investing in Vanguard’s VTSMX is $3,000.
The minimum to start investing in Fidelity’s FSTMX is $2,500.
The only difference between VTSAX/FSTVX and VTSMX/FSTMX is that VTSAX/FSTVX have a higher minimum ($10,000 instead of $3,000/$2,500) and a slightly lower cost (.04% versus .14%/.09%).
For both VTSMX and FSTMX, as soon as you reach $10,000, you get bumped up into VTSAX or FSTVX, which have the lower expenses.
From our Magic Box to index funds
We started in our perfect world where we had our Magic Box.
Then we came back into our current world and saw that stocks had the potential to be like our Magic Box in the best case, but had the potential for financial ruin in the worst case.
Finally, we took a look at index funds and saw that they offer a simpler and less risky alternative to buying individual stocks.
Based on this, here are my 2 takeaways:
- Trying to pick individual stocks is a fool’s errand. 99% of financial managers fail to beat the market. They make their living investing and they STILL fail to do better than an index fund. Don’t let financial “advisors” gamble with your money.
- As soon as you have $2,500-3,000 saved up, you should start investing through a low-cost index fund. Your greatest ally when building wealth is time. The earlier you start investing, the more time you give your money to grow.