New investors just starting out on their journey to grow their wealth may be intimidated by all the possibilities. There are thousands of companies listed on U.S. stock exchanges. Figuring out the handful that you might want to buy to create a diversified portfolio is a big task, especially for someone just starting who might only have $1,000 to invest.
The good news is that there's a great investment in which you can put your precious $1,000. It's favored by famous investors like Warren Buffett and the late Jack Bogle. And it's incredibly simple: an S&P 500 index fund. Let's see why.
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Put your $1,000 in this index fund
An S&P 500 index fund is a mutual fund or exchange-traded fund (ETF) that includes every stock tracked by the S&P 500 index. The index comprises around 500 of the largest U.S. companies that have been consistently profitable for at least one year. It's the group of stocks most people are referring to when they talk about "the stock market."
Because the basket of stocks for the fund is pre-selected by an outside committee and every company is relatively large and frequently traded, overhead costs for an S&P 500 index fund are very low. There's no stock research and limited portfolio management, and transaction costs are very low. Fund companies can pass those low costs onto investors, charging minimal fees to hold the fund.
An actively managed mutual fund might charge between 0.5% and 1% per year to invest in the fund. But you can buy an S&P 500 index fund with a fee of just 0.015%. That means you'll pay just $0.15 per year to invest your $1,000.
But here's the kicker. Most actively managed mutual funds underperform an index fund after you account for their fees in any given year. And if you look long-term, hardly any actively managed funds can consistently outperform the index after fees.
Why Buffett recommends an S&P 500 index fund
Warren Buffett recommends investors buy an S&P 500 index fund -- even over shares of his own company, Berkshire Hathaway.
There's a simple reason why he thinks most investors should stick with the index fund. It's the best possible choice "on an expectancy basis," as he put it in his 2016 letter to shareholders. In other words, if Buffett could only own one investment, it would be an S&P 500 index fund. And that's exactly what he's instructed the trustee of his estate to buy after he's passed away.
With an S&P 500 index fund, you get the diversification of owning a lot of great businesses without the cost involved in finding them. You could alternatively pay that cost with your own time, or pay a fund manager for their time (through their investment fees). But the low expense of an index fund offering great diversification makes it an excellent place to invest your first $1,000.
Which index fund should you buy?
While you might have narrowed down your investment options from the thousands of individual stocks you could buy, there are still quite a few S&P 500 index funds to choose from today -- and there are essentially only a couple of factors that separate one from another:
- The expense ratio. This is the percentage of assets the fund company charges each year. The lower the expense ratio, the less expensive it is to own.
- Tracking error. This is a measure of how much the returns of the index fund deviate from those of the underlying index. They might deviate in your favor or against you. The best index funds have a low tracking error, ensuring your returns closely match the index's.
Here are a few recommendations:
- Fidelity 500 Index Fund (FXAIX -0.34%): This mutual fund from Fidelity is a great option if you invest with Fidelity. It offers a low expense ratio of just 0.015% and boasts a tracking error of 0.01%. There's no minimum investment to buy shares. Since it's a mutual fund, it might or might not be available at your preferred brokerage firm.
- Schwab S&P 500 Index Fund (NASDAQMUTFUND: SWPPX): You'll pay 0.02% in fees to hold this mutual fund from Charles Schwab. The tracking error has historically hovered around 0.02%. Schwab has no minimum investment, either, but it's also a mutual fund that may or may not be available at your brokerage firm.
- Vanguard S&P 500 ETF (VOO 1.29%): This popular S&P 500 ETF is one of Buffett's favorites. It charges an expense ratio of 0.03% and has a tracking error of just 0.02%. It's more appealing than the Admiral Shares mutual fund version of the index fund, which charges more and requires a $3,000 minimum investment. The ETF has no minimum investment and you can buy it at any brokerage firm.
