The Power of Index Funds.

The other day I talked a little bit about investing in my Intro to Investing post. In that post I talked a little bit about what investing in the stock market is and some basic things you should know before you start. One of the things that I mentioned was index funds. These are a great way to get started in investing. They offer a great way to protect your money and still see growth in the long term. Today I’ll go over what they are and how to use them as well as why you would want to.

 

Mutual Funds

First, index funds are a special type of mutual fund. A mutual fund is an investment that just combines the money from a lot of investors, then uses that money to buy a bunch of different investments. Mutual funds usually have a theme. For example, there are mutual funds that invest in tech stocks. Those funds collect all the money from people that want to buy in. Then they use that money to buy stocks in companies like Google, Facebook, Apple, and other technology companies. There are also mutual funds that invest in healthcare companies, banks, utilities and just about any other type of investment you can think of.

Mutual funds are run by professional money managers. They evaluate the different investment options and buy and sell to meet the fund’s goals. Typically this means that the fund managers evaluate the profitability of different companies in the fund’s theme to find the best way to allocate the fund’s money to both maximize the potential profit and minimize the risks.

Advantages

Mutual funds have several advantages. The two greatest are security and expertise. Mutual funds typically invest in a large number of companies at once. In many cases hundreds or thousands of companies. This is very difficult to do when you are just starting out and don’t have millions of dollars to invest. This type of diversification can protect you in the case where one company goes out of business. If you can only buy three stocks if one company goes out of business then you could lose a third of your money. However, if you have a mutual fund that owns stock in hundreds of companies then the loss of one company won’t be noticed as much since the growth of the others will typically offset the loss. The mutual fund managers are typically experts in their field. They know a lot about the industry that they are investing in. They also know a lot about the companies they are investing in. They stay current on industry trends and read the financial reports published by the companies. This makes them uniquely qualified to pick appropriate investments in their industry. This can help because they will have a better understanding of how a company is making their money as well as the future prospects that company has. This means that they can more wisely pick how they will invest the mutual fund’s money.

Disadvantages

There are a few disadvantages to mutual funds. They can offer a false sense diversification, and they can grow less than other investments. While mutual funds invest in a lot of different companies and offer security against one company failing, mutual funds don’t offer protection against the group failing. For example, if you owned a mutual fund invested in oil stocks and the gas price drops then the price of the mutual fund will drop as well. So the fund protects you from the failure of one company, but not the drop in an entire sector. You can protect yourself from this by investing in more than one type of mutual fund. And it may be a good idea to sell the fund entirely if an industry is going away. The other major disadvantage is that they may grow slower. This is because not only do all the high performing companies make up for the low performing companies, but the low performing companies do drag down the high performing ones. So, by investing in a mutual fund you will have a lower return than if you invested completely in the high performing companies. The problem with this is that it is nearly impossible to predict who the high performing companies are 100% of the time. It’s also impossible to know when to sell and move on to the next company. Most people will accept slightly lower returns for the protection of diversification.

Index Funds

Index funds are a special kind of mutual fund. Like mutual funds they invest in a lot of different companies. The thing with index funds is that they tie themselves to a particular index. For example, there are S&P 500 index funds. These funds simply buy each of the companies in the S&P 500 using the same weighted average that the index uses. This means that the fund will go up and down pretty much matching the index. And since the S&P 500 has historically gone up and average of 9-10% a year, your investments will too.

Advantages

There are several advantages to using index funds. In addition to the advantages of using mutual funds the biggest advantage of using an index fund is cost savings. Since index funds track an existing index the fund managers don’t need to do extensive research on companies, or spend as much time on managing the investments. They simply buy the stocks based on the index. Since most of the time-consuming work is done for them the fees for index funds are typically very low. The reduced fees result in greater profits. Most actively managed mutual funds have fees that are many times the amount of the index funds. The returns on index funds are also more reliable. Since many indexes have been around for a long time it is easy to see how the indexes have grown on average. This is a good indication of how the index fund will grow.

Disadvantages

Index funds do have some disadvantages. The main disadvantage is that index funds track very large trends. This means that they rarely see big growth. So while growth will be more predictable than most other funds the growth won’t be as high as some funds. Index funds are also tied to what is in the index. Even if a fund manager knows that a company is doing poorly they can’t sell the stock as long as it remains in the index. For example, during the dot-com boom and bust the Nasdaq was heavily technology companies. So a Nasdaq index would have been heavily invested in technology stocks. As the bust happened any Nasdaq index fund would have held onto the stocks of those failing companies until they were removed from the index. An actively managed fund could have sold those stocks earlier.

 

When it comes down to it mutual funds in general and index funds in particular are great investments for first time investors. This is where I wish I had started years ago when I first started investing. Instead, I bought several random stocks I thought looked good. Most lost money. If I had invested in an index fund like the S&P 500 then it would have gone up and down over the years, but in the end would have grown 9-10% per year.

 

Index funds allow you to invest in a lot of companies which protects you from any one company failing. It also lets you see more predictable growth with your money. You don’t have to worry about trying to read a company’s financial statements. You don’t have to worry about picking the right company among the thousands of companies selling stocks. You just have to pick an index that historically grows. One example is the S&P 500. These are the 500 biggest companies in the US. Companies like Apple, Coca-Cola, and 3M. There are several index funds that track this index. Another is the Russel 2000. This index tracks small companies. They tend to have higher growth, but they are also more volatile. So you’ll see lots of dips and lots of spikes. For new investors and people who don’t want to spend their time studying financial reports this is definitely the way to go.

 

Do you invest in index funds? What do you think about it?

The Problem of Debt and How to Get Rid of It.

Americans are being crushed under debt. We borrow money to buy the things we need. More often than not though, we borrow money to buy the things we want. According to NerdWallet the average American household has over $15,000 in credit card debt. That doesn’t even include a car loan or a mortgage. And credit card debt isn’t cheap. The average interest rate on a credit card is 18%. It can go even higher.

 

Now, what does that actually mean? First, let’s look at how credit cards work. We have to go back to high school math for this. Say you buy a new TV for 500 dollars. You put it on a credit card with 20% interest. Most store credit cards have even higher interest. And, for this example say you have a minimum payment of $25 per month. That would be about typical. How much will that TV actually cost you, and how long will you have to pay for it?

 

Just to make sure we’re clear on words. Interest is what the bank charges you to buy that TV for you and let you pay them back over time. The longer you tie up their money the more they charge you. Principal is the amount you actually borrowed. So in this example it’s the $500. In most loans you pay the interest and a little bit of the principal each time you make a payment.

 

If there was no interest the math would be easy. You would divide the 500 by 25 and you would get 20 months. Now with interest it will take a little longer. Generally interest is calculated every month. The bank will usually divide your interest rate by 12, since there are twelve months in the year and that’s how much interest you pay that month on whatever is still owed. So, if you owe $500 and your interest rate is 20% per year then the bank will divide 20%/12 and charge you 1.67% interest that month. 1.67% of 500 is $8.33. So before you can even pay towards the 500 you have to pay that interest of $8.33. Typically the bank doesn’t charge interest the month you make the charge, though. So you generally don’t start paying interest if you pay for all the charges you made that month.

 

Here’s a little table showing the month, payment that month, the amount owed before the payment is made, the amount owed after the payment is made, the interest added, and the amount that will be due next month.

 

Month Payment Total Owed Before the Payment Total Owed After the payment Interest Added For The Month Total Owed Next Month
1 $25.00 $500.00 $475.00 $7.92 $482.92
2 $25.00 $482.92 $457.92 $7.63 $465.55
3 $25.00 $465.55 $440.55 $7.34 $447.89
4 $25.00 $447.89 $422.89 $7.05 $429.94
5 $25.00 $429.94 $404.94 $6.75 $411.69
6 $25.00 $411.69 $386.69 $6.44 $393.13
7 $25.00 $393.13 $368.13 $6.14 $374.27
8 $25.00 $374.27 $349.27 $5.82 $355.09
9 $25.00 $355.09 $330.09 $5.50 $335.59
10 $25.00 $335.59 $310.59 $5.18 $315.77
11 $25.00 $315.77 $290.77 $4.85 $295.61
12 $25.00 $295.61 $270.61 $4.51 $275.12
13 $25.00 $275.12 $250.12 $4.17 $254.29
14 $25.00 $254.29 $229.29 $3.82 $233.11
15 $25.00 $233.11 $208.11 $3.47 $211.58
16 $25.00 $211.58 $186.58 $3.11 $189.69
17 $25.00 $189.69 $164.69 $2.74 $167.44
18 $25.00 $167.44 $142.44 $2.37 $144.81
19 $25.00 $144.81 $119.81 $2.00 $121.81
20 $25.00 $121.81 $96.81 $1.61 $98.42
21 $25.00 $98.42 $73.42 $1.22 $74.65
22 $25.00 $74.65 $49.65 $0.83 $50.47
23 $25.00 $50.47 $25.47 $0.42 $25.90
24 $25.00 $25.90 $0.90 $0.01 $0.91
25 $0.91 $0.91 $0.00 $0.00 $0.00

 

So by having the loan you end up paying more. You pay a total of $100 in interest. Your $500 TV ends up costing you a little over $600. That’s 20% more. The loan also ties up $25 of your money every month for 24 months. Even on months that you have something more important to pay for.

 

So, next time you want to buy something with a credit card think about how long it will take to pay it off, and the extra interest you will pay. Is it worth the extra money in interest?

 

So what can you do about it? Ideally plan ahead. If you know you are going to buy a $500 TV put $25 a month in a savings account every month. Then when the account reaches $500 you can buy the TV. This way you get it for cheaper. You can also skip a month when you’re tight on money, or if something else comes up. You can’t skip a month with the credit card.

 

But what do you do with the debt you already have? There are several strategies that you can use to get rid of it. The first step to each of them is don’t add anymore debt to the card. You can see more details in my post Strategies to Pay Off Debt. Below is a summary of what you can do.

 

Step 1. Don’t add any more debt to the card.

This is probably the most important step. If you stop adding to the debt you can pay it off. If you continue to add to it you may never pay the debt off. You will simply pay the bank more and more interest making the bank owners richer and yourself poorer.

Step 2. Always pay at least the minimum payment.

The minimum payment usually covers the interest and a little bit of the principal. It’s also the least amount that you can pay and keep the bank from getting upset. Paying this amount each month will keep your account current. Many credit cards will raise your interest rate if you don’t pay this. So missing it may cost you even more money.

Step 3. Pick one card and put your extra money to it.

This is how you start to get rid of the debt. Pick one card. This could be the card with the highest interest rate, or the card with the highest balance, or the card with the lowest balance, or even the card with the company you like the least. However you decide to do it, pick one card to pay off first. Put all your extra money to it and pay the minimum balance on your other cards. As soon as this card is paid off switch to the next card and do the same thing.

Step 4. Don’t add any more debt to the card.

Once a card is paid off don’t add more debt to it. That would only continue the debt cycle. Instead think of all the extra money you’ll have left over once you pay off the cards.

 

That’s the four, really only three steps to getting rid of the credit card debt. The hardest part is the discipline to stop using the cards and to pay extra each month. If it’s truly important to you to have a strong financial future then you can do it.

 

What strategies do you use to pay off your credit cards? Any strategies to keep yourself from using your cards?

Welcome.

Sometimes it seems like just yesterday, and sometimes it seems like a long time ago. But when I started on this journey I had a negative net worth. I owed people more money than I had. Yup I added it up. If I sold everything I owned I wouldn’t be able to pay my debts. I wasn’t making much money, and perhaps I spent money on things I shouldn’t. When I looked at that I knew it wouldn’t work. I knew I couldn’t do that for much longer.

 

So, I decided something had to change. So over the years I fixed my income, I fixed my debt, and though I’m far from rich, I’m on my way to gaining financial security. That took a lot of effort. I spent time reading and trying new things. I failed a lot, but I learned more and eventually had more successes than failures. A lot of what I learned came from reading books and the blogs written by people that had been where I’d been. That’s where I think that anyone struggling with money should start. Learn from those that have been there.

 

One thing I did find difficult though is that a lot of blogs and books are written for people that already make good money. They help people refine and get better. But they assume you’re starting a bit further along than I knew I was. I had to fill in a lot of those gaps in other ways. Some of that by asking questions and learning from people that have been there.

 

So what does this mean for you? Well, this means we know how you feel. Whether you’re just starting out on your journey or you’ve been working on it for a while. We’ve been there. Here you’ll find information on how to start out. You’ll also learn how to put some of these ideas to work for you. We’ll share our failures, so you can learn to avoid them. We’ll also share what we’ve learned since starting out so wherever you are in your journey you’ll be able to make things easier.

 

Learning about money isn’t hard. Sometimes it takes work follow through with what you learn, but anyone can do it. No matter where you’re starting from it is possible to get better. Even if you have nothing now it is possible to retire given time and effort. Retirement is Possible.

 

We look forward to sharing what we’ve learned and learning with you as we move forward. If there is anything in particular that you want to hear about email us or post it in the comments.