Episode 5 of the FrugalPod podcast is online and ready for download. You can also subscribe to the podcast via its RSS feed or through iTunes. As always, we encourage you to post your comments, questions, and suggestions for future episodes in the comments section on the blog. Thanks for listening and we hope you enjoy the show.
We’re also giving away 2 copies of The Little Book of Common Sense Investing by John Bogle (the founder of Vanguard Funds) to people randomly selected from those who comment on this post.
Episode 5 Show Notes – An introduction to Investing.
Intro to Investing
When you buy stock in a company, you own a small part of the company. This entitles you to a share of the profit. Hopefully the company will increase in value over time, and that will cause the price of the stock to go up.
If the company earns money, many companies decide to share these earnings with the shareholders in the form of dividends.
For the average investor, making money in the stock market by buying and selling individual shares is very difficult. Even 50% of professional money mangers don’t do better than the average performance of all stocks.
By buying a mutual fund, you are able to pool your money with others’ and a professional investor decides what to buy and sell.
When deciding what mutual funds to buy, there are firms such as Morningstar (link to Morningstar.com) that rate and rank mutual funds. The problem with rating firms is that most ratings are based on previous results.
Index Funds
Vanguard (link to Vanguard.com) offers index funds such as the Vanguard S&P 500 Index that simply buy every stock in the index. Because no research is required in doing this, the cost is much lower with these funds. The average mutual fund charges $10 to $15 per $1,000 invested (1.0 to 1.5%) each year to manage investors’ money. The Vanguard s&P 500 Index charges about $2 per $1,000.
The Other Costs of Mutual Funds
Besides fees, taxes on index funds tend to be less than actively managed funds because stocks trade less often in an index. The average index fund may sell 10% to 15% of the stocks in the portfolio, while the average actively managed fund may trade 80% of the stocks in the portfolio each year.
How to Get Started
If you already have an investment account and you want to use index funds, you have a few options. First, your discount broker may offer their own index funds. You should understand the fees charged by the fund. When I did a quick search for index funds at Charles Schwab, I found they offered one fund (SWPIX) that is a true S&P 500 index fund (meaning it invests only in the 500 largest public companies in America). For every $1,000 invested, the investor will pay $3.50.
Compared to Vanguard (which charges $1.50 per $1,000 invested), the Schwab fund seems a little rich. But at Schwab, there is a $49.95 cost to trade some mutual funds but not others. As you might imagine, Schwab doesn’t charge a fee to trade their own index fund, but Vanguard’s fund costs $49.95. In order to recapture two times the fee (you’re charged when you buy and when you sell), on an $1,000 investment, it would take 20 years to re-capture the transaction fees through lower costs. On the other hand, on a $10,000 investment, it will take four years because the trading cost represents a much smaller percentage of the account value as you invest more.
If you are not already investing with a a discount broker, you can also open an account directly with Vanguard and invest in their funds without paying transaction fees.
You can also open an account at any discount broker and look at using exchange traded funds (ETFs). ETFs trade like stocks but behave (more or less) like mutual funds. In the case of the S&P ETF that trades under the stock symbol SPY, the cost is $1.10 per $1,000 invested, which beats the Vanguard fee by almost 27%. Also, ETFs may trade at much lower costs and have lower minimum investments than mutual funds.
Conclusion
There’s a lot to cover in investing, even on a single topic such as investing in index funds. We’ll continue to talk about investing, both in index and actively managed mutual funds, so keep coming back.
{ 2 comments… read them below or add one }
Thanks for all of your fantastic tips. I look forward to the next podcast!!
Wow, thanks for explaining in a clear, easy to understand way! Great podcast!