The reason for the title of this post is not because I think it is boring, or that you will think it’s boring or even that the subject matter is boring. It happened one evening while at work.
I was at a mandatory work function talking with three colleagues. There was a break in our assignments and we were having a chat. At some point the subject of finance and investments came up. I was asked what I do with the money I save each year and I eagerly began discussing the details of index funds. Before I could get too far into the benefits of investing in index funds, including instant diversification, one of my coworkers proclaimed, “This is so boring”, and simply walked away.
At the time, I could not believe what happened. Not because I was insulted that someone walked away while I was in mid-sentence – that had happened before. Not even because someone thought that the sounds coming out of my mouth were boring – I have most certainly bored plenty of people in my time with countless stories and insights into life. No, what I couldn’t believe was how someone who was in the same state I was in with regards to salary, and who I knew for a fact had no current investment plan, would sacrifice the opportunity to learn how to make a return on her savings simply because she thought it was boring.
Perhaps I was boring in the way I was discussing index funds and for that I will accept responsibly. But if that were the case, she should have said, “You are so boring”, not “This is so boring.” I mean, don’t take it out on the index funds!
In light of the accusation, I shall do my best to make this post, which I believe to be important as non-boring as possible.
Before we get into index funds, it may be helpful for a little discussion about what it is to “invest” in the stock market. When someone invests in the stock market, what they are doing is investing in a company whose shares of stock are bought and sold on a daily basis. When a company wants to raise money, one of the ways it can do this is to sell stock. Basically the company is selling little pieces of ownership in the company to raise money. Why would a company need to raise money? The main reason is to grow. Companies need investor capital (a fancy word for money) to expand their business. It is why Facebook began selling shares of stock in 2012 and why Coca-Cola began selling shares of stock in 1919.
When a company “goes public” it is taking the value of the company and splitting it up into numerous shares of stock. For instance, if Facebook was worth $1,000,000 and wanted to go public, it could issue shares of stock. Let’s say it wanted to issue 1,000,000 shares. Then each share would be worth $1. So if you bought one share you would now own a tiny piece of Facebook. In this scenario Facebook would be able to “raise” $1,000,000 by selling pieces of ownership to the general public, hence the term “going public”. Once the initial shares are sold to the public and Facebook has raised its money, those same shares continue to trade in the stock market and their prices will go up and down depending on whether people want to own the shares or not. Facebook will make no money off the people buying and selling the shares after the initial sell because those shares are being bought and sold by the general public. So if you sell your one share of Facebook, you get the money, not Facebook. And if you sell that share, it will be someone other than Facebook buying it.
So why would you want to own a piece of Facebook? Well, if you thought it was going to expand and make more money than it already does, then you would expect the price of the stock to go up. For instance, if you would have bought a share of Coca-Cola stock in 1919, you would be expecting that Coca-Cola would use that money to expand its business and ultimately make more money – and you would have been right.
In hindsight, investing in Coca-Cola looks like a no brainer, but what about investing in Facebook? That is not as easy to determine. This brings up another component of investing – risk. Anytime you take your money and attempt to invest it there is risk. If you invest in Facebook, you could lose a substantial amount of money if the company is mismanaged or if all the sudden a better social media platform comes along. Even the Coca-Cola investor in 1919 was undoubtedly a bit nervous about buying a piece of a company peddling what amounts to sugar water. This is where the word “diversification” comes into play. I am sure you have heard the phrase, “don’t put all your eggs in one basket.” What exactly does that mean? Well, if you put your eggs in one basket and that basket breaks and all your eggs fall to the ground, no omelet for you. Perhaps it would be better to carry two baskets, or three, or four, or three-thousand baskets. This is what is meant by stock diversification – to not only own a piece of Facebook, but also of Coca-Cola and of every other public company available to investors.
One way to diversify is by buying a mutual fund. Mutual funds are funds that own shares of many different companies. To use our analogy, your eggs have been divided nicely into a variety of baskets decreasing your risk. But there is a problem with mutual funds – someone is in charge of deciding which companies should be in the mutual fund. And for their time and effort they are going to charge you a fee. Think of it as someone charging you to go and pick out your baskets for you. Even though you bought the baskets and the eggs, you are paying the fund manager for picking out the baskets. Why would anyone do this? Because the mutual fund manager tells you that he knows a lot about baskets and he will pick just the right ones needed to carry your eggs. What’s the problem with this? Well, this guy doesn’t really know anything more about baskets than anyone else. As a matter of fact, history shows that if you could just buy all the baskets available, some would be great, some would be good, others would not last so long and some would break altogether. But the point is, as times goes on, baskets get better and stronger and are better at carrying your precious eggs.
So instead of paying a manager and using the mutual fund approach, you want to use the index fund approach. An index fund owns shares of many different companies, just like the mutual fund, however with an index fund no manager is picking the stocks because the fund tracks an index. For example, my favorite index fund, and that of countless others, is the Vanguard Total Stock Market Index Fund (VTSAX). This fund tracks the entire United States Stock Market and owns nearly 100% of the companies in that market, some 3,800 companies. Now that’s a lot of baskets. The other index fund I own is the Vanguard Total International Stock Index Fund (VTIAX). This fund owns stock in over 5,900 different international companies. This is a cost-effective way to own shares of international companies while ensuring much-needed diversification.
By investing in these two funds, an investor is able to have nearly 10,000 baskets to put his eggs in. In this way, if one company weakens it is of very little significance to the overall portfolio. The idea is that, over time, companies will increase their earnings which in turn drives up their stock price, which in turn results in a favorable return for the investor. Sure, not every company will succeed, but those that don’t will be naturally left behind, making room for a new company.
It is up to the investor to determine the ratio of U.S. Fund vs. International Fund to hold, but based on the risks of the two markets, 75% in the Vanguard Total Stock Market Index Fund and 25% in the Vanguard Total International Stock Index Fund is a sound strategy. Therefore, if you had $100,000 to invest, $75,000 should be in VTSAX and $25,000 in VTIAX. And as you continue to add to your portfolio, you would naturally rebalance as necessary to achieve this ratio.
For a deeper insight into these two funds we can look at their percentage of return over the years. Even though historic appreciation is no way to determine future returns, it does give us an idea of past performance. Based on the Vanguard website, and as of this writing, the Vanguard Total Stock Market Index Fund (VTSAX) has had a return of 6.66% since its inception in 2000 and the Vanguard Total International Stock Index Fund (VTIAX) a return of 5.91% since its inception in 2010. In addition to looking at the returns of a fund in terms of appreciation, there are also two other important components to be aware of: dividend yield and expense ratio.
The dividend yield is the percentage of the stock price, or in this case fund price, which is being paid to the investor each year in the form of dividends. Currently, VTSAX has a dividend yield of 1.76% and VTIAX has a dividend yield of 2.5%. So using the above scenario of $100,000 to invest, $75,000 in VTSAX and $25,000 in VTIAX, let’s figure out how much money we would make in dividends each year.
- $75,000 x 1.76% = $1,320
- $25,000 x 2.5% = $625
So each year you would make an additional $1,945 in dividend income. This would be deposited into your investment account in four different installments every three months. The great thing about this is that this is a guaranteed 1.945% return on your $100,000 in addition to any appreciation of the fund itself. Furthermore, you can choose to use this money to automatically buy more shares of the fund, which adds more overall wealth to your portfolio and will compound over time.
As your wealth grows this 1.945% becomes quite impressive. If you had $1,000,000 invested, it would be $19,450 every year in addition to the return of the overall fund itself. So if you earned 7% on your one million in the form of fund appreciation, you would be earning $70,000 (7% x $1,000,000) plus the $19,450 from dividends. Now you start to see what people mean when they say, “have your money work for you”.
Another very important part of any fund is its expense ratio. An expense ratio is basically how much the investment costs you to own. I am sure you have heard about certain mutual funds charging the average investor more than they make each year in returns. While this may be an exaggeration, it is certainly true that many funds that are actively managed do charge high fees to pay for those who are doing the managing. One of the wonderful things about Vanguard Funds is that they have very low expense ratios.
For instance the expense ratio for VTSAX is 0.04% and VTIAX is 0.11%. What this means is that you will pay this percentage of your holdings to Vanguard each year as a fee. It is important to note that you can invest in these funds through “Admiral Shares”(which is what I own and am quoting) or “Admiral Shares”. The difference in the two is that Admiral Shares require a minimum investment of $10,000 and the Investor Shares require a minimum investment of $3,000. Since the Admiral Shares require a higher minimum investment, the fees are lower than for the Investor Shares which have an expense ratio of 0.15% and 0.18% for the Total Stock Market Index Fund and the Total International Stock Index Fund, respectively. Other than that, both Admiral Shares and Investor Shares are invested in the same fund of companies. Based on the Admiral Shares, let’s look at the above $100,000 to see how much you will be paying in fees to own these two funds:
- $75,000 x 0.04% = $30
- $ 25,000 x 0.11%. = $27.50
So for $57.50 a year you can invest $100,000 in 3,800 U.S companies and 5,900 international companies. You would enjoy a 1.945% return in dividends plus any appreciation of the overall funds (which is historically at least 5%) for a total yearly return of at least $7,000 and as much as $9,000 (if we assume a 7% return based on the historical performance of the overall market).
If you had an investment of a million dollars the numbers would look like this:
- $750,000 x 0.04% = $300
- $ 250,000 x 0.11%. = $275
For fees of $57.50 a year you would be looking at $19,450 worth of yearly dividend income ($1,000,000 x 1.945%)plus appreciation of both funds at 5-7%, for a total yearly return of at least $70,000 and as much as $90,000. Now you can call that boring if you want, but I think it is pretty damn exciting!