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Why S&P 500 is the Best Index Fund for the Average Investor | Stock Market Explained for Beginners

At this point, I know you’ve heard all kinds of great things about the stock market and how it’s this amazing wealth-creating tool. But how does it really work? Could you lose your hard-earned money?

Let’s get into it. In this email, we will go over stock market basics:

How you make money in the stock market

Different types of investment vehicles

On the go? You can the video here:

Defining the Stock Market

We’ll start by defining the term “stock market”. A market is where you buy and sell goods – in this case, you buy and sell stocks. A company’s stock is just another word for a company’s value. And that value is divided up into shares.

Most of the largest companies in the world are publically traded on the stock market and you will have access to buy a small share of their stock.

So the stock market is a place where you can buy and sell companies, but you can’t just hit up Elon Musk and ask to buy a share of Tesla. You have to buy and sell your shares through a broker, which is simply a middleman for the transaction.

Common stock brokers in the US include Fidelity, TD Ameritrade, and Vanguard. You simply go to their website, set up an account, and deposit some money.

Now let’s get into why you might want to participate.

How You Can Make Money in the Stock Market

A publically traded company literally has ONE function above all others: maximize profit for the owners of the company – the owners being the shareholders. If you buy the stock, then you are the shareholder. Legally this is true.

If the directors or executives of a publically traded company are shown to go against this legal duty – known as fiduciary responsibility – they will be vulnerable to a class action lawsuit and can be sued for damages.

Additionally, the shareholders hold voting power over the directors and can remove them from their positions. So LEGALLY, the people who control the company are doing everything in their power to put money in your pocket.

Now there are generally two ways that a company can return value to you, a stock shareholder and we will talk about each detail.

1. Dividends

After a company pays all of its employees and expenses and replaces its inventory or equipment, any revenue left over is profit that can be passed on to its shareholders. This sum of money paid to shareholders out of a company’s profits is called a dividend payment. In most cases, a company will pay a set amount every quarter.

One metric that most investors will look at when analyzing a dividend-paying stock is by looking at its dividend yield. This just means the percentage of the share price that gets paid out in a single year.

So if a share of a company’s stock is worth $100 and it pays $2.50 per quarter, then it pays $10 per year and that would be a 10% dividend. That would be a very high dividend yield.

The average dividend yield is probably somewhere between 1 and 3% for example. Now, there is a lot more that goes into analyzing a dividend stock, easily enough to have its own video.

Okay, so the more profitable a company is, the more it can pay its shareholders! And the more a company pays its shareholders, typically, the more a single share will be worth.

This brings us to the second way you can make money by owning stock.

2. Value Appreciation

Let’s say the going rate for a single share of company X is $100 and every year you get paid $5 in dividends. You could say this company pays a 5% dividend. After a few years, the company is able to do more BUSINESS and they announce that they will now pay $10 per year – a 10% dividend.

Assuming nothing else is wrong with the company, if you and the rest of the market were willing to invest $100 to get $5 in return before, the same ratio would hold true. The company would increase in value so that a single share now costs $200 which restores the old dividend percentage of 5%.

This is great news for you though, because you bought the shares for $100 and now you can sell them for $200. Pretty straightforward.

But, what if a company never pays you a dividend? Why would anyone buy a stock that would never pay them? That’s a good question lol. And the answer is the potential for greater profit in the future.

Imagine a company that is primed for amazing growth. They have a market that is begging for their product but they don’t have the equipment or space or whatever to deliver. They are profitable now, but if they hold back on paying a dividend this year, they can use that profit to expand into another market and make way more in the future!

If this scenario of increased profits seems pretty likely to the public, then the stock price will go up in anticipation. Now you can sell that stock for more than you bought it for without ever being paid by the company.

Of course, it doesn’t always pan out this way, and just like with dividend companies, there are tons of nuances to analyzing growth stocks. Now even with a growth stock, at a certain point, growth WILL slow down.

Eventually, spending money on trying to grow doesn’t result in much more future profit. You could say the dollars used to grow the company are not used efficiently.

Imagine someone told you, this dollar is yours, but if you let me keep it I will turn it into $1 and 1 cent in 5 years! You’d be like no thanks, I’ll just take my dollar now. Once this situation happens for a publically traded company, they start to pay a dividend.

Okay, so from these two different modes of profit, a sort of pattern emerges.

And yes there are loads of exceptions to this rule but I think it’s a good starting point.

Even with your newfound knowledge of the stock market, picking a company that you want to invest in is still a daunting task. Some companies fail, after all, so there is no guarantee that the one you select will make money.

The solution to this problem is investing in a fund.

Different Types of Investment Vehicles

There are two basic types of funds: actively managed funds and passively managed funds.

1. Actively Managed Fund

An actively managed fund, also known as a hedge fund, is run by a team of professional investors. You give them your money and they take it from there, picking companies that, according to their research and expertise, they believe will outperform the rest of the market. They also seek to time the market to sell when it’s high and buy when it’s low.

This sounds great in theory but not all active managers are created equal. It is very difficult to find the ones that are actually skilled. If you just pick one that’s doing well at the time, it’s possible they were just on a lucky streak that’s about to reverse.

On top of that, their services are not free. Generally, you are charged a small percentage every year whether your investment goes up or down. This yearly fee deceptively adds up quite a bit over many years.

Interestingly, one of the greatest and most famous active fund managers of all time, Warren Buffet, issued a challenge in 2008 to the hedge fund industry, specifically the funds that charged exorbitant fees. The challenge is that over the next decade actively managed funds would lose to a passively managed fund (the S&P500) after you account for the difference in fees.

Buffet was so confident that he put 1 million dollars on the line, and Protégé Partners LLC (a hedge fund) accepted the challenge. Here is the result.

Warren Buffet’s Million Dollar Bet on Hedge Fund vs. Index Fund

As you can see, the passively traded fund was crushed in this case. The five active funds selected by Protégé Partners LLC had, on average, a cumulative return of just 22% compared to the S&P 500’s 85%.

2. Passively Traded Funds

So let’s talk about passively traded funds. The most common example is an index fund, which seeks to track a predetermined financial market index. The S&P 500 is a prime example.

The S&P 500 invests in the 500 largest US companies and is weighted by market capitalization. This just means, proportionately, the bigger the company, the higher the percentage of the fund.

For instance, the largest company in the US at this time is Apple and it makes up 7.03% of the S&P 500 while the 300th largest company is Ulta and it makes up just .06%.

This is considered a passive fund because the managers don’t need to make any decisions on what to buy or when. They just observe the market and follow the predetermined rules of the index fund.

A passive fund does not need to do heavy market research or hire experts to time the market so it can afford to have much lower fees.

Again, using the S&P 500 as an example, the annual fee percentage is just 0.03% if you invest in Vanguard’s Fund which has the symbol VOO. Compare this to a typical actively managed fund which averages between 0.5% to 1%.

That doesn’t seem like a huge difference, but let’s do some math!

You plan to invest $10,000 for 30 years. Let’s assume you get an average annualized return of 10% over that period in both cases.

When you have a fee of 0.03%, you end up with $163,000 after 30 years. When you have a 1% fee, which doesn’t seem like much, you end up with about $123,000!

That means you would be paying about $40K on your $10K investment over 30 years.

As you can see, even a small percentage can add up to a significant amount of money over a long period of time. Which, if you are investing properly, you should be investing over long periods of time.

It really is hard to go wrong with a quality index fund like the S&P 500 if you invest and stay invested over many years. With the 500 biggest US companies, this fund does a great job tracking the US economy.

As long as the economy is doing well, your investment will be doing well. It’s kind of like the whole country is working for you.

With this video, you will be well-equipped to succeed in the stock market. Remember, the best time to start investing was 100 years ago, and the second best time is right now.

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