For anyone who is a complete beginner to investing, let me explain the three main ways to invest in the stock market. The first way is to buy individual stocks. The second way is to invest in actively managed funds (Mutual Funds). Finally, the third way is to invest in passively managed funds (Vanguard Index Funds). Mutual funds invest in a changing list of stocks chosen by the manager of the fund. An index fund – S&P 500 index fund for example, invests in the 500 best stocks in the United States.
Individual stocks, when done correctly with sound discipline and understanding of investing, will give you the highest rate of return. However, the fact is that the average person is not willing or able to put in this time. Suppose someone did put the time in to learn how to value stocks and invest with discipline. The odds are that they still wouldn’t beat the market (S&P 500) over the long term.
Here’s how a Vanguard Index Fund works
1. BORING IS BETTER
Everyone wants to pick individual stocks and get the highest return possible. I’ve been there too, and I’ve done that. What we fail to consider is the bull market doesn’t last forever, bear markets follow, and recessions can happen. We also fail to consider our downside risk. If you lose 50% in a stock, you now must make a 100% return to break-even. If you lose 75% over your investment in a stock now you must make 300% to break-even. With the S&P 500 index, you are well diversified by sector. If one sector declines, your losses will be offset by gains in another sector. The difference is, instead of losing 50 to 70 percent of your money, you would be down 10 percent for instance.
2. WARREN BUFFET SAYS SO
Buffett has said the best single thing you could do is “buy an index fund, never look at headline, not think about stocks”. Warren buffet has also said that his kids’ inheritance will be put in an S&P 500 Index Fund
3. LOWER FEES
VFV.TO (Vanguard S&P 500 Index ETF) has an MER (management expense ratio of 0.09%). In contrast, most mutual funds offered by the big banks in Canada have an MER of between 0.5% and over 2%.
To illustrate the long-term difference between these two management fees let’s assume that both options give you an 8% return annually on $10,000 invested. We’ll use a 1% MER for mutual funds and 0.09% for the Vanguard Index ETF.
Example A (Vanguard S&P 500 Index ETF): after 40 years you end up with $1,153,473.18
Example B (Mutual Fund in Canada): after 40 years you end up with $891,207.18
That’s a difference of $262,266 that you paid in additional fees.
4. TRACK RECORD
The S&P 500 index has returned an average annualized return of 11.88% from 1957 to 2021.
5. IGNORANCE IS BLISS
Using a platform like WealthSimple Trade you can now set up automatic deposits and recurring buys, while paying no fees. This will enable you to make one simple index fund purchase every month, using only a few minutes of your time to set this up.
