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How to Invest in Index Funds (Beginner’s Guide)

Starting investing is not always easy. It can actually be frightening.

Investing is one of the best things you can do to your money and future self so if you are just starting out, or never thought about it yet, this is the perfect beginner’s guide to help you become an index investor. Throughout this guide, you will learn the must-know basics about index investing, how to open a brokerage account, how to build the perfect portfolio and how to start investing like a pro.

 

What you will learn in this post

 

Definitions

First of all, let’s go over a few terms before we start.

  • An index or stock market index is a measurement of a section of the stock market. In other words, it is simply a bundle of stocks and it tracks the prices of said selected stocks. It is a tool used by investors and financial managers to describe the market and to compare the return on specific investments. The Dow Jones Industrial Average (DJIA) is the most common one and one of the oldest. Other examples across the world are the S&P500, TSX, the Nasdaq Composite, or the Nikkei 225.
  • An index fund is a mutual fund or exchange-traded fund (ETF) designed to track a specified basket of underlying investments.
  • An index investor or indexer is an investor who prefers using index funds rather than trying to beat the market. Active investors try to use their skill (or luck) to pick the best stocks or funds but this may take a lot of time, skill, and luck. Statistically, the odds are against them. Out of all actively managed mutual funds, a whopping 82% of them did not constantly beat the index over the last decade. That is why the index investor prefers to be passive. They look to match the market returns instead of trying to pick stocks or time the market, they manage their expected risk and return by diversifying their investments.

 

How does an index fund work? From Youtube

 

Index investing is so effective

Index investing has been around for a while and it has been great to the ones who stuck with it. Trying to pick the next big winner or trying to time the market is, statistically, a loser’s game. The majority (over 80%) of professional actively managed fund managers cannot beat the index benchmark over the long-term. If even a cat can beat professionals three-folds, who to trust?

 

Share of U.S. stock funds outperformed by their indexesSource: Year-End 2014 SPIVA U.S. Scorecard from S&P Dow Jones Indices

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As an average investor, your chances are even slimmer! This super interesting study found that average investors are often underperforming the market by 4 to 5 percent, often because of failed attempts to time the market. The time, fees, knowledge, and luck involved simply work against you.

 

The latest study looks at the 20-year period that ended Dec. 31, 2009:

  • Average investment return = 8.20 percent
  • Average equity investor return = 3.17 percent

If you had put money into an S&P 500 index fund 20 years ago and just left it there — no buying, no selling, just investing and forgetting about it — you would have earned (minus fees) about 8 percent. – Carl Richards

 

As a passive investor, you simply buy all of the assets represented in the indexes you chose. In this example above, a passive investor would have grown his wealth, on average, 8.20 percent per year. That’s doubling your money every 8.8 years!

 

Managers of an index or passive approach believe it’s difficult to outthink the market because markets are highly efficient—at any moment, prices reflect what is known about each security. – Vanguard

 

The efficient-market hypothesis is a theory that states that stock prices fully reflect all available information.  Since no one actually the true value of a certain stock and everyone has all available information, there is an equal chance that stocks are under or overvalued at any point in time.

In other words, it is impossible to “beat the market” consistently on a risk-adjusted basis since market prices should only react to new information. The market should always price stocks correctly.

 

To summarize the Efficient Market Hypothesis: An investor cannot earn a return without an appropriate amount of risk. A return without risk would be an abnormal return, and this is nonexistent in an efficient market. – Dr. S

 

Think about it this way; most investors, professionals and individual investors alike, lose to the market.

Therefore, market returns are actually above average!

 

https://www.youtube.com/watch?v=XievFMEBZKo

What Are Index Funds? From Youtube

 

Index investing is so affordable

One of the biggest reasons that index investing is so effective is because it is so darn low-cost. No one can predict the market, no one can control returns, but one thing you can control is your costs. Most companies now offer funds with fees around the 5 basis points.

That is effectively 0.05%. We are far from the 1%+ most active funds charge.

Matt over at Mom and Dad Money wrote a great article about the effectiveness of cost on returns. He mentions that the investment research company Morningstar conducted an interesting study to see which variable was better at predicting a mutual fund’s future return and they found that the lower cost mutual funds in their study outperformed the higher cost ones in 100% of the comparisons they ran.

By controlling your cost, you can save hundreds of thousands of dollars over the next few decades. That’s right, hundreds of thousands!

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Definitions

  • An annual expenses ratio or management expense ratio (MER) is a fee, shown as a percentage, to pay for the expertise and administration to manage a fund. If you invest $1,000 in a fund which charges a 1% MER, for example, you would pay $10 per year to the fund company. This would be paid whether the fund goes up or down.

 

According to Morningstar, the average equity mutual fund MER in Canada is 2.35% and the average account over the investment lifetime is $229,000. This tally up to an average management fee of $323,654 over a lifetime!

Think about this figure for a minute.

The average equity mutual fund MER is more than 10 times more than Vanguard’s index funds average expense ratio of 0.18%. This means the average investor losses roughly $300,000 in fees.

 

Investors wasted more than $100 billion over the last decade on expensive advice. – Warren Buffett

 

Index funds the very simple job to track the market and they do it without the pros and their big bonuses. That simplicity keeps costs low, and those low costs are passed on to you in the form of higher returns. The other beauty of indexing is that it does not require much of your time and it will let you focus on other things!

Become an indexer

The best way to know how much a fund will cost is to look at the fund’s overview or fund fact.

For Vanguard funds lookout for something like this:

U.S. stock funds fees

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Notice the Expense ratio of 0.04%. This is one of the lowest in the business.

For Fidelity funds lookout for something like this:

Fidelity fund fee

 

For Blackrock funds lookout for something like this:

Blackrock iShares fund fee

 

To find this information, and much more, you will need to look at the fund’s Factsheet.

The factsheet is a document provided by the fund manager that gives you an overview of the fund. It includes key information such as the fund’s investment objective, its top 10 holdings and how it has performed in the past.

This can help you decide whether the fund is a good match for your portfolio or not. You can click on the example below for more details.

 

How to read a fund factsheetSource: Standard Life Self-Investor

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Index funds are (mostly) diversified

Apart from the cost, a huge factor in their effectiveness is their diversification. Diversification is just another fancy word to say; don’t put all your eggs in the same basket.

 

Plan your Health

 

If you invest in your favorite companies, let’s say 10 of them, or even 50 of them, you are not really diversified. Your chances of success are pretty slim.

Even if you would be able to cover most sectors of the economy, such as technology, financial services, consumer cyclical goods, or utilities, you will miss some and/or be overweight in certain ones.

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Definitions

  • Being overweight in a sector on a particular investment, as part of a three-tiered rating system, along with underweight and equal weight, refers to the balance of your investment portfolio. If you own $80 of bananas and $20 of oranges and the market represents $5,000 of bananas and $5,000 or oranges, you would be overweight bananas, underweight oranges. An equal weight representation in this example would be to own $50 of bananas and $50 of oranges to have a similar weighting as the total market.
  • An asset allocation is the representation of your portfolio. In the previous example, your asset allocation would include bananas and oranges.

 

Asset allocation is one of the great tools investors use to lower risk and increase returns without significant additional costs. Harry Markowitz even proposed the idea that diversification is, in fact, the only free lunch in investing.

As Vanguard puts it, indexing is a great way to spread out your investments to avoid losing your shirt to a bankruptcy or a particular sector crashing. Instead, it allows you to participate in the market as a whole.

Vanguard risk of indexing

Source: Vanguard

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Risk spectrumWhen an investment is said to be risky, that simply means that there is uncertainty about its returns. Stocks, for example, can swing up and down every day and, over the long-term, can generate double-digit returns but might not be ideal over the short-term.

On the other hand, keeping all your money in guaranteed investments such as a savings account is unrecommended for a long-term objective since inflation will likely wipe out your returns and the opportunity cost would simply be too large.

You can read more about the risks and rewards in investing in this article from Vanguard or this one from The Balance.

Unfortunately, picking an index fund does not guarantee it is diversified. Any Dow Jones index fund will lack diversification, for example, because the Dow is a stock market index that tracks only 30 large publicly owned companies based in the United States. It does not include all the sectors of the economy, only tracks large companies, and is only based in the U.S.

However, a fund which tracks the S&P500 would include 500 companies, but again, focuses on large companies in the U.S.

When choosing index funds, you should consider three main things. Firstly, the total number of stocks held, then, the annual expenses ratio or MER, and lastly, the ease of use, ie. how easily tradable it is, (we will get to this).

  1. A good index fund should hold at least 1500 individual stocks,
  2. should have a low management fee (0.05% to 0.30%),
  3. and should be easy to buy and sell at no or very low cost.

Diversification can be an amazing tool but beware of di-worse-ifying. Having too many funds might be worse than too little. We will cover different portfolios later but try to keep it simple.

Invest in a handful of largely-diversified funds, in investments you understand are ready to hold for the long-term.

 

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When to start investing?

Now that we have covered the basic, it must sound so simple to just throw money in these funds and make a quick buck but it is not that easy.

Indexing is not a get-rich-quick scheme, on the contrary.

Index investing takes time, consistency, and perseverance but it can be very rewarding over the long-run.

Index investing is easy to start, but hard to keep up.

As the great Warren Buffett puts it; Put your long-term investments in an index fund, learn to save, and when it falls, buy, don’t sell.

 

Financially Blind

 

The secret is to start investing early and to stay consistent. Over an investing career, consistency can be the difference between working until 55 or 75 years old! The chart below is the perfect argument for consistency. If you try to time the market, missing only the ten best days of the year cut your average return by almost half!

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Historical returns of marketSource: JP Morgan Funds

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Start early and keep investing, no matter the moods of the market. In the example below, we illustrate how a constant $5,000 yearly investment can grow over time in different scenarios.

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How to start investingSource: JP Morgan Funds

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A long time horizon also amplifies the advantages of tax-differed accounts but we will get to those shortly.

Over and over again, the market had huge run-ups and crashes but high savers with a long-term investment goal should be happy and jump on those bargain prices. Staying on the sidelines will not make you rich.

The best day to start investing is today.

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What if the market crashes?

As JL Collins would say; The market always recovers.  

 

Always.

 

He explains in his amazing Stock Series that the market is simply the single best performing investment class over time and it always goes up. Over the long-term of course.

He goes on to say that the market is self-cleansing, the bad companies die off and the new ones appear. When a company goes bankrupt, its stock goes to zero. It is a 100% loss. However, when the winners thrive, their stock can rise 200, 300, 1,000, 10,000% or more.  There is no upside limit!

Owning stocks is owning real companies, employing real jobs, making real products. When you invest in index funds, you are investing in thousands of companies. You are investing in the economy.

Even if you where to invest today and the market crashes tomorrow, you will still be fine over the long-run.

There is a classic example of Bob the world’s worst market timer. In this example, Bob invests at every high of the market, just before every major recession. His plan was to save $2,000 a year during the 1970s and bump that amount up by $2,000 each decade until he could retire at age 65 by the end of 2013.

Bob did not invest early, instead, he waited to see huge market run-ups before, finally, investing his savings. The market dropped nearly 50% in 1973-74 and Bob had invested everything at the peak of the market right before the huge crash. The same thing kept happening to Bob but he never sold. He stayed the course, staying constant and saving a bit more every year even if he always waited for run-ups before investing.

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How to time the marketSource: A Wealth of Common Sense

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Even investing only at the very highs of the market, Bob would still end up with major profits (around 10.1% annualized since 1970) if he simply sticks to index investing and does not panic. He still ended up a millionaire with $1.1 million in investments simply because he did never sold and kept his consistency.

Market crashes are actually healthy for investors. It is very unlikely you will end up investing like Bob but even if you do, it’s fine. We covered in-depth the reasoning behind this in a past article but indexing would not be the same without the occasional corrections and crashes.

The beauty of crashes is that it gives the advantage to long-term investors who are still buying in and reinvest their dividends. When everything is down, everything is on sale!

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Step one: Choosing your account

Alright, now that we covered the basics, you can take the first concrete steps towards building your wealth. There are many options you could use such as your bank’s services, mutual fund companies, independent brokers, or robo-advisors but with so many options comes so many price-points and fees.

Just as we mentioned earlier, fees are super important. Keeping your costs low can save you thousands of dollars along the way. Below are the top low-fee options we think are the best for you. They each have their own characteristics but they would all be a fine pick to start your investment journey.

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Ally: Best overall broker

Ally Invest tutorialIf you do not already have a self-managed investment account, we suggest Ally. They are, by-far, the best low-cost online broker available. They offer fixed, low, $4.95 commissions and other bells and whistles such as forex trading and automated portfolio management.

For new clients, they offer a $200 cash bonus or 90 days or free trades. Their customer service is great, fees low, and their online platform was recognized as #1 for usability by Barron’s.

Ally Invest, formerly TradeKing, won multiple awards and recognition over the years.

  • 4-stars from Barron’s “Best Online Broker” review for every year since 2007.
  • Barron’s distinguished as one of the “Best for Options Traders” and one of the “Best for Long-Term Investing”.
  • SmartMoney Magazine named them #1 in customer service in 2008, 2010, and 2011 annual rankings and  #4 overall in 2011 annual rankings (#1 overall in 2006 and 2007).

They do not require any minimum balance to open an account and the whole process may take you about 15 minutes.  The only drawback is that they do not support 529 accounts yet.

 

Free trade with Ally

 

The first step to open your account is to fill out basic personal information. Then, you will be able to fund your account and start trading.

 

Opening an account with Ally

Opening an account with Ally2

Opening an account with Ally1Source: Ally account opening

 

Once your account is open, you can explore the Dashboard and start investing. They offer plenty of information and fun tools but if you are sticking to an index fund portfolio, you will not need all this. We will cover the basics of buying orders in the next section below.

 

Vanguard: Trade Vanguard funds for free

Vanguard TutorialThey offer free trades for their mutual funds and ETFs but do charge almost double than Ally for any other trade ($7) which is much less attractive. However, they do offer the option of 529 accounts not offered by Ally.

The first step to open your account is to fill out basic personal information. Then, you will be able to fund your account and start trading.

 

Opening an account with Vanguard1

Opening an account with Vanguard2Source: Vanguard account opening

 

Wealthsimple: Best for hands-off investors

wealth simple logoThey offer a fully-hands-off approach to index investing. They can help you build smart portfolios and can give you advice on how to achieve your financial goals. In only 5 minutes, you can sign up online, answer a few questions, and they will figure out the best investment strategy for you.

They will buy a diversified mix of low-fee index funds optimized for your situation and manage those investments for you. Unlike the brokers discussed earlier, Wealthsimple is a robo-advisor which will rebalance your account to make sure you stay optimally diversified as the value of your investments changes. We will show you how you can do all of this on your own later but if you do not want to spend the time needed for DIY investing, Wealthsimple is a great option.

How to invest with Wealthsimple

Wealthsimple iphone appWhat we like about them is that their fee structure is simple and low-cost. They only charge a management fee once your account surpasses $5,000 and do not charge any other account management fee or hidden fees.

  • 0.0% fee for accounts below $5,000
  • 0.5% fee for accounts up to $100,000
  • 0.4% fee for accounts above $100,000

If you are looking for a hands-off approach to passive investing, Wealthsimple is the way to go.

 

Wealthsimple-US-Account-options

Wealthsimple-whats-your-primary-reason-for-investingSource: Wealthsimple account opening

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Questrade: Best broker for Canadians

questrade account openingFor Canadians, both Wealthsimple and Questrade are great options. Questrade is a self-directed broker and offers free purchases of exchange-traded fund purchases (ETF) and super low commissions of 1¢ per share on all the rest.

They do charge an inactivity fee if you do not execute one commissionable trade per quarter (3 months) or hold at least $5,000 in value within your account.

Use the promo code 595806512417973 and receive up to $250 once you’ve opened your account.

 

How to open an account with Questrade

Questrade coupon 250 code

Source: Questrade account opening

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How To Open A Questrade Account From Youtube

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To recap, each of the options above has different purposes and different structures but they are all great to start investing. Ally is our best pick overall and Questrade is right up there with them but for Canadians. As for Vanguard, we absolutely love their funds but their trading accounts only offer advantageous commissions on Vanguard products. For a more hands-off approach, Wealthsimple is an amazing robo-advisor and operates both in the U.S. and Canada. If you are still wondering if DIY investing is for you or not, we will cover trading in the next section.

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Best discount broker

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Once you have chosen the option which best suits you can begin your account opening, you will need to choose the type of account you wish to open.

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  • Traditional 401k – This is a plan established by your employer to which eligible employees may make salary deferral (salary reduction) contributions on a post-tax and/or pretax basis. Earnings in a 401(k) plan accrue on a tax-deferred basis.
  • ROTH 401k -This is also an employer-sponsored plan but where contributions are made with after-tax dollars, investments grow tax-free, and withdrawals are also tax-free.
  • Traditional IRA – A traditional individual retirement account where contributions are tax-deductible, investments grow tax-free, but withdrawals are taxed as income. The maximum annual contribution limit is $5,500 and eligibility for this account depends on family income (or single income). To qualify for an IRA, you need to make a combined income of less than $186k.
  • ROTH IRA – Similar to the traditional IRA, the Roth contributions are made with after-tax dollars but the contributions are not tax deductible. Investments grow tax-free, and withdrawals are also tax-free. Just like the traditional IRA, there is a maximum contribution limit of $5,500 with the same eligibility rules.
  • SEP IRA – This is an IRA for small business entrepreneurs and allows for large lump sums to be deposited into a tax-sheltered account.  The guidelines can be found here.

 

best-retirement-accounts-chartSource: Let’s Automate Your Money

 

In Canada, it is simple,

  • TFSA – This is an account that does not charge taxes on any contributions, interest earned, dividends or capital gains.  The contributions are not tax deductible but withdrawals are tax-free.  The contribution limit was increased every year since its creation in 2009 and stands currently at $5,500 annually.
  • RRSP – This is a retirement saving and investment vehicle for employees and the self-employed in Canada. Pre-tax money is placed into an RRSP and grows tax-free until withdrawal, at which time it is taxed. This account has many features in common with 401(k) plans in the United States.

 

Which account should you start with?

With so many different investment accounts available, you should prioritize and contribute where your dollar will do best.

 

Investment accounts you should prioritize, in order.

  1. Contribute to your company’s plan (401k, 403b) to get the full employer match.
  2. Participate in your employer’s stock option plan if they offer a match.
  3. Contribute to a Health Savings Account (HSA) if available.
  4. Contribute the maximum to an IRA, traditional or Roth.
  5. Contribute to the maximum limit of your work-based plan for tax advantages.
  6. Contribute to taxable investing accounts.

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Investment accounts you should prioritize, for Canadians

  1. Contribute the maximum to your RRSP.
  2. Participate in your employer’s stock option plan if they offer a match.
  3. Contribute the maximum to your TFSA.
  4. Contribute to taxable investing accounts.

 

Best ways to start investing

 

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Step two: Building your portfolio

Once you have chosen a broker, you will need to fund your account and start investing. With all of them except Wealthsimple, you will need to do your own research, build your portfolio, place your own orders, and rebalance your holdings every now and then. Before we dig into all of this, let’s cover a few terms.

 

Definitions

  • A mutual fund and an ETF both represent professionally managed collections, or “baskets,” of individual stocks or bonds such as index funds. Most funds are offered in both options but they do differ. ETFs offer greater flexibility when it comes to trading but usually involve a trading commission. However, they usually have lower expenses than a similar mutual fund and have better tax treatment.
  • A ticker symbol is used to trade on the exchanges. Mutual funds, for example, usually have 5-letter tickers such as (VTTHX) and ETFs usually have 3-letter tickers such as (VTI).
  • A stock is a share in the ownership of a company while a bond is a debt security issued by a corporation or government. On the risk spectrum, stocks are considered riskier than bonds.
  • A dividend is a distribution of a portion of a company’s earnings. In the case of index funds, the dividend represents all distribution from the companies held within the fund.
  • An asset allocation is a way one splits his portfolio’s assets according to his goals, risk tolerance, and investment horizon.

 

Before you even start building your portfolio, you need to decide how much you are ready to invest. We discussed the difference between lump sum investing and dollar cost averaging in a previous article and concluded that the best thing to do is to go all in at once. If you have $1,000 to invest, do not try to time the market by investing $100 at the time when you feel the market is low, research has shown that you are more likely to maximize your returns by investing all of your $1,000 right from the start.

How to start investing

 

 

Jack Bogle on Asset Allocation and Market Collapse From Youtube

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Having a strong investment plan and being diversified will not save you from a market crash. It is healthy for the market to correct itself. Ups and downs simply mean that the market is volatile but you can use this volatility to your advantage with dividend reinvestment and consistent investments.How to use an etfNow, once you funded your account, you need to choose the funds you wish to invest in. As discussed earlier, diversification is a great way to manage your risk and returns. We covered example portfolios before but let’s look at a few concrete examples.Tips to invest in index etfYou would be surprised to find out that the dozen different mutual funds your advisor used to diversify your portfolio could easily be replaced with only 2 funds; a U.S. Total market fund such as VTSAX (ETF ticker VTI) and a bond fund such as VBTLX (ETF ticker BND). JL Collins explains this concept beautifully in his Stock Series, we highly suggest the read. He goes into the details of default risk, interest rate risk, and inflation risk in his Part XII-Bonds.

We have discussed bonds before, they are essentially a debt security issued by a corporation or government. They offer interest and on the risk spectrum, they are considered safer than most other investments, although, they are not guaranteed. Generally, adding bonds to your portfolio tends to lower both risk and potential return.

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Potential reurns stock vs bondsSource: Vanguard

 

Learn how to invest

There are an infinite amount of portfolio combinations but really, the simplest ones are often the best. There is no perfect portfolio but keeping it down to only a few funds will be cheaper, easier to manage and rebalance, an, hopefully, increase your total returns over the long-term.

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All-in-one portfolios

The simplest portfolio is the one-fund solution. When your portfolio includes a different fund for each asset class, it is easy to dwell on the individual parts rather than the whole and lose sight of your long-term goal.

Some funds adjust their asset allocation over time. Called lifecycle or target-date fund, these are a great one-fund solution. The dates in their names refer to your anticipated retirement dates as these funds start off more aggressive (more stocks) and end up holding a more conservative portfolio (more bonds) by the retirement date.

 

How to buy funds vanguardSource: Vanguard

 

iShares offers many of these as with expense ratios around 0.43%.

  • iSharesiShares S&P Target Date 2020 Index Fund (TZG)
  • iShares S&P Target Date 2025 Index Fund (TZI)
  • iShares S&P Target Date 2030 Index Fund (TZL)

Vanguard offers similar funds with an average expense ratio of 0.13%.

  • Vanguard TutorialVanguard Target Retirement 2035 Fund (VTTHX)
  • Vanguard Target Retirement 2040 Fund (VFORX)
  • Vanguard Target Retirement 2060 Fund (VTTSX)

Charles Schwab offers with an expense ratio of only 0.08%.

Charles Schwab target funds

  • Schwab Target 2025 Index Fund (SWYDX)
  • Schwab Target 2035 Index Fund (SWYFX)
  • Schwab Target 2050 Index Fund (SWYMX)

 

Another option is asset allocation funds offer varying exposure to stocks and bonds depending on how aggressive a portfolio you want. Unlike target-date funds, they do not change over time. If you invest in a balanced fund, it will keep that allocation.

 

iShares offers many of these as with expense ratios around 0.46%.

iShares

  • iShares S&P Conservative Allocation Fund (AOK)
  • iShares S&P Moderate Allocation Fund (AOM)
  • iShares S&P Aggressive Allocation Fund (AOA)

Vanguard offers similar funds with an average expense ratio of only 0.14%.

  • Vanguard TutorialLifeStrategy Conservative Growth Fund (VSCGX)
  • LifeStrategy Moderate Growth Fund (VSMGX)
  • LifeStrategy Growth Fund (VASGX)

Charles Schwab offers with an expense ratio of 0.59%.

Charles Schwab target funds

  • Schwab MarketTrack Conservative Portfolio (SWCGX)
  • Schwab MarketTrack Balanced Portfolio (SWBGX)
  • Schwab MarketTrack Growth Portfolio (SWHGX)

 

How to buy funds Schwab

This Schwab fund, for example, is composed of American stocks, international stocks, emerging markets stocks, bonds, and cash. This would be a suitable one-fund option but we prefer the Vanguard funds given their lower fees.

In Canada, Vanguard has recently released tree all-in-one funds. The Vanguard Conservative ETF Portfolio (VCNS) holds 40% stocks and 60% bonds, while the Vanguard Balanced ETF Portfolio (VBAL) uses the opposite proportion. The most aggressive version, the Vanguard Growth ETF Portfolio (VGRO), is 80% equities. All three ETFs carry a very competitive management fee of just 0.22%.

Dan from the Canadian Couch Potato has done a great piece on Vanguard Canada’s portfolios.

Useful guide to index investing

Alternatively, you could also try Vanguard’s Investor questionnaire. Knowing your risk profile is the key to a proper investment portfolio. If you take on too much risk for your appetite, you might sell at the wrong time or make rash decisions.

Finally, the Total Stock Market Portfolio is a very popular choice for long-term investors. The Vanguard Total Stock Market Index Fund (VTI or VTSAX), for example, offers great diversity at a hyper-low cost.

It holds over  3613 American companies, ranging from small- to large-sized. The average rate of return on this portfolio since 1972 has been 7.5%.

Some argue that owning only American companies does not provide enough diversification while others argue that most U.S. companies operate internationally anyways. We have talked about global returns in the past and we believe having a global exposer is important to diversify a portfolio. One way to build a globally-diversified portfolio is to follow the relative size of each market across the globe.

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Relative sizes of world stock markets, How to build your asset allocation and invest in a diversified portfolio.Source: Credit Suisse Global Investment Returns Yearbook 2014

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Another way would be to own a risk-appropriate proportion in accordance with your own risk profile. Since global markets have, historically, been more volatile than the U.S., your allocation might be slimmer in said markets.

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Source: Vanguard

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For a global exposer, you can look into the iShares MSCI ACWI Index Fund (ACWI), with 2,467 stock holdings and management fees of 0.35 percent. A lower-cost option would be the Vanguard Total World Stock ETF (VT), with 2,894 holdings and management fees at 0.25 percent.

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Other DIY portfolios

If you want a bit more control over your investments, you can create your own asset allocation. Let’s start with the Classic 60-40 which is comprised of 60% Total Stock Market and 40% Total Bond Market. This often serves as the benchmark in most portfolio discussions and has been around for ages as the go-to portfolio.

Best asset allocation portfolio for your age

Possible fund combinations:

  • Vanguard Total Stock Market ETF (VTI), expense ratio of 0.04% 
  • iShares Core S&P Total U.S. Stock Market ETF (ITOT), expense ratio of 0.03% 
  • Schwab Total Stock Market Index (SWTSX), expense ratio of 0.03% 

 

  • Vanguard Total Bond Market ETF (BND), expense ratio of 0.05% 
  • iShares Core U.S. Aggregate Bond ETF (AGG), expense ratio of 0.05% 
  • Schwab US Aggregate Bond ETF (SCHZ), expense ratio of 0.04% 

 

With an average rate of return since 1972 of 5.8% and a  low standard of deviation of 11.6%, this portfolio has been a stable winner over the past decades. If you are looking for considerable returns, without taking on too much risk, this is a good option.

Another great option is the Three-Fund Portfolio. It is very similar to the Classic 60-40 but includes in international exposure to the mix. For this portfolio, we include 3 funds; 40% Total Stock Market, 40% Total Bond Market, and 20% Total International Market.

Best asset mix for you

This one shows an average rate of return since 1972 of 5.8% with a low standard of deviation of 11.4%. It is very similar to the Classic since the stocks and bonds allocation is the same.

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Possible fund combinations:

  • Schwab Total Stock Market Index (SWTSX), expense ratio of 0.03% 
  • iShares Core S&P Total U.S. Stock Market ETF (ITOT), expense ratio of 0.03% 
  • Vanguard Total Stock Market ETF (VTI), expense ratio of 0.04% 

 

  • Vanguard Total Bond Market ETF (BND), expense ratio of 0.05% 
  • iShares Core U.S. Aggregate Bond ETF (AGG), expense ratio of 0.05% 
  • Schwab US Aggregate Bond ETF (SCHZ), expense ratio of 0.04% 

 

  • Total International Market (VXUS), expense ratio of 0.11% 
  • iShares Core MSCI Total International Stock (IXUS), expense ratio of 0.11% 
  • Schwab International Equity ETF (SCHF), expense ratio of 0.06%

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As for us, we the core of our portfolio in 4 index funds; Vanguard Total Market ETF (VTI), Vanguard FTSE Canada All Cap Index ETF (VCN), Vanguard FTSE Emerging Markets ETF (VWO), and Vanguard Total Bond Market ETF (BND). We have a slightly different approach since we are Canadian but you can see our exact asset allocation in our Open Book series.

 

Mr. Asset Allocation Mrs. Asset Allocation
  • 40% ♦  US Market
  • 30% ♦  Canadian Market
  • 25% ♦  International Market
  • 5%    ♦  Bonds
  • 45% ♦  US Market
  • 40% ♦  Canadian Market
  • 10% ♦  International Market
  • 5%    ♦  Bonds

 

More helpful videos

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Step three: Placing your orders

Once you have found out your risk profile and investment horizon, you can choose your own asset allocation and start placing purchase orders.

 

Definitions

  • limit order is an order to buy or sell a security at a specific price or better. A buy limit order can only be executed at the limit price or lower, and a sell limit order can only be executed at the limit price or higher.
  • market order is a buy or sell order to be executed immediately at current market prices.
  • The ask price is what sellers are willing to take for a security. If you are selling a stock or a fund, you are going to get the bid price, if you are buying a stock you are going to get the ask price.

 

The basics look almost the same with any broker; you open a trade, then, select the ticker and quantity you wish to purchase with the limit price you wish to pay.

 

ally-invest-live-review-4Source: Ally order entry

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You need to go under the trading tab, enter the ticker symbol under quote as shown in the fund’s Factsheet or online. For the Vanguard Total Stock Market ETF, for example, you would enter the symbol: VTI.

How to buy a stock

Then, it will quote you the current price as well as the bid and ask. If you simply put a market order, you will pay the ask price and if you are selling a stock or a fund, you are going to get the bid price.

There is also an additional risk to putting market orders since you do not know the exact price you will be paying or selling.

We suggest putting a limit order, you can then choose your own price. In the example beside, the current bid is 137.51 and ask is 138.16. If you were to set a limit order to buy at 138.00, you will most likely find a seller willing to meet you at that price and you will have saved 16¢ per share. You could also look at the day’s or 52-week range and enter a lower bid, hoping the price will drop. You would then enter a duration for your trade such as Day if you want your order to be valid for the whole day or select a future date if you are making a low bid.

For the quantity, you will need to divide the amount you want to invest by the price you will be bidding per share. For example, if you wanted to invest $5,000 in VTI at $138.00, you would place a limit order for 36 shares.

Beginners guide to index investing

With Vanguard, the process is fairly similar but their order screen is much simpler and to the point.

Stocks ETFs order entry with Vanguard

For mutual funds, the whole process is much easier. All you need to do is enter the ticker symbol and the amount you wish to invest. Mutual funds do not trade on the market all day so you will simply get the closing price of the day. All you need to do is say how much you wish to invest and where is the money coming from.

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QuickStart_VanguardFundsSource: Vanguard order entry

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Similarly, Wealthsimple is super simple! They even include it in the name. To start investing with Wealthsimple, all you need to do is fund your account and they will do all the rest. They will help you with financial planning and building the perfect portfolio of ETFs, automatically rebalance your account, and help you make the tough decisions when the markets are going down.

How to invest with Wealthsimple

Finally, placing orders with Questrade is just like with Ally. If the process is still unclear for you, we suggest the video below which looks at the whole process in details.

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How to Build an ETF Portfolio at Questrade From Youtube

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Rebalancing

Once you have built your portfolio and are ready to sit it out for the long-term, you still need to make sure things stay within your risk profile over time. At least once a year, but not too often, you should review your portfolio and rebalance if your asset allocation is getting away from your original plan.

Original Allocation  Current Allocation
U.S. Index 50% 45%
International Index 25% 30%
Bond Index 25% 25%

 

As you can see in the above example, our original asset allocation was spread across the major indexes. Over the year the international equity has increased by 5%, while the U.S. index has decreased by 5%.

To rebalance we would simply “switch” 5% of our international equity into U.S. equity. If you would be using ETFs,  you would sell some International Index and then buy some U.S. index. By sticking to this strategy we’re essentially selling high and buying low while sticking to our original risk profile.

 

 

Final thoughts

Congrats! You are now an index investor. Now, the secret is to stay constant and continue investing, no matter what the markets are doing.

 

The markets are up, great continue investing.

The markets are crashing, great continue investing. It’s on sale!

The markets are flat, great continue investing.

 

If you keep this up with a long-term horizon in mind, your portfolio will continue growing and you will reach unimaginable wealth.

If you have any questions, anything, don’t be shy to ask in the comment section below.

 

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Categories
Financial Independence

What is Money and How to Make it

This week, I have been reading The Wealth of Nations by Adam Smith. This 1776 masterpiece reflects upon economics, the division of labour, productivity, and free markets at the beginning of the Industrial Revolution. However, even if it is centuries-old, it is still very enlightening and I highly recommend you pick up a free copy at your local library.

It got me thinking how strange it is that things you value the most for their use have often very little value in exchange and those with the greatest value of exchange have very little use.

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Nothing is more useful than water: but it will purchase scarce anything; scarce anything can be had in exchange for it. A diamond, on the contrary, has scarce any value in use; but a very great quantity of other goods may frequently be had in exchange for it. ― Adam Smith

 

What is MoneyMoney has almost no use at all in its true form. You could make a paper plane out of it or you could do a little Origami project. It is an amazing way to exchange and store wealth but that is only true when people believe in it. The U.S. dollar is a strong medium of exchange right now but what about the Uzbekistani Som which just lost 48% of its value last September.

The same can be said of Bitcoins or other cryptocurrencies; they only hold value if people trust them and keep exchanging them. Cryptos are valued because people accept them, it is decentralized and in limited supply, and it can act as an equity investment. There are also other technological benefits the blockchain can offer but that’s a whole other story. In the end of the day, people need a medium of exchange and store wealth they can trust.

 

Invest in the people

Another great way to store your wealth is by investing in hard-working companies that will put your money to work. We invest in thousands of great companies around the world through index funds. Behind any index fund hides real companies and behind every company hides hard-working employees. Anyone who is investing in the Vanguard Total Market Index, for example, is investing in the workers of America; producing, creating, and exporting around the globe. Anyone who is investing in VTI is investing in the American people.

 

The first $100,000 is a b*tch, but you gotta do it.

Growing wealth is hard and the first milestones seem to take forever to reach but compound interest is always around the corner to save you. As the vice chairman of Berkshire Hathaway and billionaire, Charlie Munger, puts it; “The first $100,000 is a b*tch, but you gotta do it.

Even in the 18th-century, Adam Smith understood that the first $100,000 is the hardest! OK, maybe he did not say the same thing word for word and after inflation, it would be something more along the lines of; “The first 10¢ is the hardest.” 🙂 What he actually wrote was;

 

Money, says the proverb, makes money. When you have got a little, it is often easy to get more. The great difficulty is to get that little. ― Adam Smith

 

Understand the power of compound interest and get it to work for you, not against you. If you live below your means and are a net saver, you will be miles ahead of anyone living paycheck to paycheck. Start early and start strong.

 

The magic of compound interestSource: The Cooperators

 

Automate your finances

The best way to reach your goals is to automate most of the processes and stay constant. Once you have a money flow system in place, you can let it build your wealth with minimal intervention.

  1. Start by signing up for direct deposit at work to receive your paycheck directly into your account.
  2. Contribute to your RRSP (401k) at each paycheck and contribute at least enough to maximize the match. The more you can contribute, the better.
  3. Set up an automatic transfer between your checking account and your savings account. You can even set up different savings account for your different goals. There should be enough in there to cover any emergencies and large purchases coming up.
  4. Set up an automatic transfer between your checking account and your investment account, TFSA (Roth IRA). Select an asset allocation that works for you and invest every month or every paycheck.
  5. Put all your bills on direct payment with your credit card. You will get to accumulate rewards and you will never be late again.
  6. Pay your credit cards in full every month from your checking account.

 

 

Money Flow Chart - How to Budget

 

The secret here is to do small changes in your life and optimize your finances one step at the time. Once you found something that works and that is easily replicable, automate it and move on. By doing this, you are leaving it all to atomization and focusing on what matters most.

 

Automate your finances

 

There are a lot of new apps out there to help you automate your finances. Here are a few that we know of but we are not affiliated with any of them. Most of them are only for Americans so we never got the chance to try them out so please do your own research.

  • Find, cancel, and negotiate subscriptions and save automatically with apps like Trim which will negotiate for you and find some savings for you.
  • For everyday spending, apps like Acorns to round up your purchases to the nearest dollar and invest the change. The Qapital app even lets you set rules like the 52-Week Challenge Rule and also links up to IFTTT (“If This, Then That”) for further customization. Another cool savings app is Stocard. We actually use this one a lot to accumulate reward points and travel the world for free. When shopping online, you can also use apps like Honey to automatically find coupons and savings on your everyday purchases. An even easier version of this is Dosh which automatically saves you money on each transaction.
  • Tip Yourself is a fun app that lets you give yourself a tip whenever you do something awesome. It is a cool concept that plays into the psychology of money to help you repay debt, or save for your goals, faster. Apps like Pay Off Debt are a great way to manage your debt and chose the most efficient repayment method while staying motivated.
  • The best thing you can do to automate your investments is to participate in your 401k or Employee stock option if you have one. This is free money that you simply cannot leave on the table. Elect to contribute automatically every paycheck, set an asset allocation that works for you, and forget about it. For all your other investments, you can use the wealth management services from Personal Capital and benefit from their holistic financial planning approach or set-up an automatic investment schedule with a broker such as Ally.

It is hard to accumulate wealth but anyone can do it. Being rich does not mean you are a billionaire, not even a millionaire. Being rich simply means that you can afford to enjoy the necessaries, conveniences, and to be happy.

Financial independence does not have a number attached to it. It is built around principles and a way of life. Live a conscious life and save consistently by living on less than you earn. Avoid debt, invest in investments you understand, and keep at it until you have reached your goals.

Be happy, Xyz.

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