Financial Independence Part 3: Investing in Index Funds

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I am not a financial advisor and am not giving financial advice. The content of this article is informational only and based on my own experience.

Welcome to Part 3: Investing in Index Funds! Now that we’ve covered the fundamentals, let’s talk about investing in the stock market. If you’re new to the idea of putting your money into stocks, or know about it but just haven’t pulled the trigger, you aren’t alone – the first step is nerve-wracking! So to get you more acclimated, let’s talk about what I invest in to build wealth toward FIRE.

Stocks Are Scary

Well, yeah – the news makes everything sensational and anxiety-inducing! I’ve dabbled in individual stocks, but I honestly don’t recommend it. I made a little money in the GME and AMC experiment when they were blowing up, but that was an emotional rollercoaster that I’m not keen to hop back onto at all! There’s a lot that goes into choosing specific stocks – is your focus short-term gain? Long-term buy and hold? Options trading? Calls? Do you believe in the company? It’s just way too much work to learn it all and try to beat the algorithms handling millions of trades every day in fractions of a second.

Consider this instead. Let’s say there’s a way to invest your money where, long-term, the value has always gone up. This investment shifts its holdings regularly to ensure that only the most profitable companies are included, phasing out any that fall below a specific threshold. Some have even provided an average return of 13.94% over the last 10 years. They also distribute dividends, have multiple options to get started based on your financial situation, and have some of the lowest fee structures in the business. Interested?

This isn’t made up, and it isn’t a scam. What I’m talking about are index funds.

What are Index Funds?

An Index Fund is a type of mutual fund or exchange-traded fund that aims to track the returns of a market. This means that whatever the index does, the index fund does as well. Let’s look at VTSAX, or the Vanguard Total Stock Market Index Fund. This investment tracks companies across the entire US market, including small, mid, and large-cap growth and value stocks.

Looking at VTSAX compared to the S&P 500 over the last year, you can see that the two trend very similarly to one another. Whatever. the S&P 500 does, VTSAX follows.

Now let’s look at the S&P 500 since 1950.

Pretty impressive track record, huh? In the long term, the index always goes up. This is why I feel extremely comfortable investing in index funds. But what about you? I’m sure there are a few questions you have about how the process will affect you – let’s get to those next.

How Will Index Funds Help Me Meet My Goals?

What’s better – putting money into a savings account or investing in the stock market? One is certainly safer, right? While there can be definite comfort in putting your money in an account that’s backed by the government in case something terrible happens, we need to see what you’d lose if you put money into savings instead of index funds. Let’s take a look.

How much would I make in a Traditional Savings Account?

If we look at the average interest accrued in a US-based savings account, you’ll find that you can expect to receive around 0.07%. Yep, you read it right – less than one-tenth of a percent. To put that into context, if you had $10,000 sitting in a savings account from 2010-2020 and didn’t add anything more, in 10 years you’d have…

Drumroll please…

$10,070.22. You’d make 70 dollars in 10 years. But wait, that doesn’t account for inflation! If we factor in the average inflation rate of 2.75% (2010-2020), the purchasing power actually drops to $8,484.46. You’re losing money if you only put money in a savings account.

What about a High-Yield Savings Account (HYSA)?

Well, these are sitting at a high of 1.26% at the time of this writing – but out of a list of 22 institutions outlined by Bankrate, only 7 are above 1%. Let’s do the math for these next.

Assuming the same $10,000 as before, from 2010 to 2020 you’d have made $1,333.90, for a grand total of $11,333.90. If we account for inflation, we’ll still find that we’re losing money with a real purchasing power of $9,549.15. That’s a loss of $450.85. It’s even crazier if you look at 2022’s inflation – a whopping 8.6% so far, compared to no more than 2.1% from 2012 to the end of 2020.

What would I see in the same 10-year period with index funds?

Great question! $10,000 worth of VTSAX in 2010 would amount to $46,930.41 in 2020. Quite a jump, right? Now just imagine what it would be if you’d been investing a significant portion of your income for that entire 10 years.

How do index funds combat inflation, you ask? Well, the beautiful thing about investing in the index is that however those companies perform, your investments will follow in kind. If prices increase and the companies increase their profits, your portfolio value will reflect that as their share prices increase. When looked at it in this way, your investments are safe from inflation in the long term.

It is worth mentioning that the 2009 to 2022 bull run was the longest bull run in history. A bull run of this length is not something we should expect in the future.

But Dave, the sirens are blaring right now and the market is either stagnant or down! Are you still investing? Or are you throwing money in a mattress?

What I Do When The Market Drops

Flashback: It’s 2009 and the stock market just crapped the bed, bottoming out at a 54% decrease from the previous 2007 high. Alarms are going off, every news station is telling you that the world is ending, and you’re wondering (if you still have a job)…What do I do with my investments?

There are 3 options.

Sell

Nope! Don’t do it! The only way to truly capture a loss is to sell at a loss. If you’ve been investing in index funds, panic selling when the market is down is going to lose you serious amounts of money. An index fund like VTSAX will not drop to 0 because it always holds the best-performing companies in the index. If index funds did drop to 0, well…your retirement accounts will be the least of your worries, because we’ll be back to bartering pots and pans for food as the world burns around us. Remember that, as we discussed before, the market always goes up in the long term.

Hold

This is the second-best option for anyone. If you’ve lost your ability to continue to invest, the bare minimum you should do is hold on to your index fund investments.

Buy

If you’re able, this is the strongest time to buy index funds! It’s known as “buying the dip” – you buy when the price drops, letting you acquire shares at a discount. This is how many people grew significant real wealth during and following the Great Recession. Those that continued their normal investment schedule came out way ahead as the market recovered and continued on to the longest bull run in history.

What Do I Invest In?

I personally invest in VTSAX and VTI for index funds. I’d also invest my 401(k) in this as well, but my employer’s plan doesn’t allow it. Instead, I’m investing in a long-term retirement option through my 401(k) provider.

Before moving on to discuss what a 401(k) is, let’s first go through the differences between VTSAX and VTI.

  • VTSAX – Vanguard’s Total Stock Index Fund requires a $3,000 investment to start, however this allows the investor to purchase fractional shares. This means whatever you have available to invest can go right into the account – you don’t have to buy a whole share at a time.
  • VTI – Vanguard’s Total Stock Market Index Fund Exchange Traded Fund (ETF) has no initial requirement, however it does require that you purchase whole shares. This means if the share price is $300 and you have $590, you can only buy 1 share. You’d need the full $600 to purchase two.

Don’t Forget Your Employer’s 401(k)!

In case you aren’t sure what it is, a 401(k) (or 403(b) for teachers) can be a tax-deferred or tax-sheltered account. Tax-deferred means that you pay taxes on the money when you withdraw instead of when you put the money in. This has two major benefits:

  • Money invested into a 401(k) pre-tax reduces your taxable income. This can be really useful in reducing your tax burden every year, particularly if you’re on the edge of a new tax bracket. As of 2022, you can invest $20,200 per year pre-tax, which will reduce your taxable income as well!
  • Retirees typically claim lower income in retirement than when they were employed, resulting in them falling into a lower tax bracket. If you’re paying 25% while working, but you’ll pay 0-10% as a retiree, when would be the better time to be taxed? As a retiree in a lower tax bracket, of course!

A tax-sheltered account means you won’t be taxed on the money ever. This applies to the Roth 401(k). Roth accounts take after-tax contributions, meaning you’ve already paid tax on the money when it’s put in the account. This could be useful if you expect to be retiring in a higher tax bracket than you are currently and would rather pay the taxes now.

Lastly, a very important point: If your employer has a match on your 401(k) contributions, typically up to a certain percentage, you’re leaving part of your salary on the table if you don’t capture that contribution.

Where Should I Go To Learn More?

Please note that when you buy something using the retail links below, we may earn a small commission at no additional cost to you.

I’ve got a number of resources to recommend for those looking to dive in further!

Books

Internet Resources

Conclusion

All right, let’s recap!

  1. Individual stocks are risky
  2. Index funds are the easiest, most hands-off path to long-term wealth
  3. Warren Buffett himself has said that index funds make the most sense practically all the time to those looking to grow their wealth
  4. Historically, the stock market always goes up in the long-term
  5. Selling your index fund shares in a market downturn is the worst thing you can do and a guaranteed way to lose money
  6. Holding or buying more shares of an index fund in a market downturn is buying at a discount!
  7. If you want to have an emergency fund, I recommend using a HYSA (high-yield savings account) to minimize the impact of inflation as much as possible
  8. Invest in your 401(k) at least up to the employer match. This is a part of your salary!

Thoughts on investing? Successes to share with your own strategies? Share in the comments!

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David

Father, fitness nut, nerd. True to form, my favorite things in life are my family, my fitness, and optimizing my financial well-being. Oh, and video games.