Index Fund Investing: Is it easy or too easy?

Index Fund Investing: Is it easy or too easy?

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Low-cost Index funds are a very low maintenance method to produce solid total returns and future cash flows.

Picture this: you’re sipping a piña colada on a beach, your bank account quietly growing while you perfect your sandcastle-building skills. Sounds like a dream, right? Well, index fund investing might just be the closest thing to a “set it and forget it” wealth-building cheat code as it gets.

It’s not a get-rich-quick scheme by any means. But it’s a solid strategy for those who want their money to work harder than a caffeinated intern. Let’s dive into what index funds are, how to best use them, and where they fall short.

Benefits of Index Fund Investing

Index funds are like the Swiss Army knives of investing—simple, versatile, and reliable. They’re mutual funds or exchange-traded funds (ETFs) designed to track a specific market index, like the S&P 500, which represents the top 500 companies in the U.S.

Instead of trying to outsmart the market (spoiler: most active fund managers can’t), index funds aim to be the market, delivering returns that mirror the index’s performance. The reason this works is because the market is always trading on information that is currently known and speculating on the future. No one can predict the future so it's extremely difficult to pick WHICH of the stocks in the index will perform better than the average. History shows that buying some of everything usually outperforms amateurs, semi-pros, and even pros.

Another reason why index investing works is because the masses of investors are doing it. Seems silly but its true. When the majority of 401k accounts are on auto pilot investing into index funds that ensure a steady demand for those stocks.

Why else are they a fan favorite? First, low costs. Index funds are the Costco of investing—cheap but high-quality. They have lower expense ratios (often below 0.1%) compared to actively managed funds (0.5%-1% or more), meaning you keep more of your returns. Second, diversification. One index fund can give you a slice of hundreds of companies, spreading your risk faster than gossip at a family reunion. Third, consistency. Historically, the S&P 500 has delivered average annual returns of about 7-10% after inflation, making index funds a reliable long-term bet. They’re ideal for beginners, busy professionals, or anyone who’d rather not spend their weekends analyzing stock charts.

Of all the passive income strategies (there are 7 classes of passive income assets, you can learn more on our website) I believe that dividend stocks is one of the MOST passive. Consequently, index fund investing is the most of the most passive. It's so simple you can set it up in an afternoon and never touch it again. Now that's passive!

Shortcomings of Index Funds

Index funds aren’t perfect—they’re more like a trusty sedan than a flashy sports car. For one, you’re not going to beat the market. You get the market’s average return, which is great over time but won’t make you the next Warren Buffett. Also, I know what you're thinking:

"Garrett, the dividend yields are so low."

True, often 1-2% for broad-market funds like the S&P 500. If you’re hunting for immediate cash flow, you might feel like you’re squeezing water from a rock. Lastly, market risk is real. If the market tanks, your index fund will too. If you are looking for alpha returns (better than the market) you need to look elsewhere.

However, this is a commonly overlooked concept for many investors. Even though the dividend yield is "low" on index funds today, it will grow. To understand this you must consider yield on cost.

Historical Performance and Yield on Cost Illustration

Let’s break down how yield on cost works with a hypothetical $10,000 investment in an S&P 500 index fund. Assume a starting dividend yield of 1.5% ($150/year) and an average annual return of 8% (dividends reinvested). Here’s how it looks over time:

• 5 Years: Your investment grows to ~$14,693, and your new annual dividend is ~$220. Yield on cost: 2.2%.

• 10 Years: Now it’s ~$21,589, with dividends of ~$323. Yield on cost: 3.2%.

• 20 Years: Your portfolio balloons to ~$46,610, paying ~$699 in dividends. Yield on cost: 7.0%!

That’s right, your original $10,000 keeps spitting out more cash each year, even if the fund’s yield stays constant. But it is expected that yields on major index funds will also rise over time.

Expense Ratios and Total Return

Let’s illustrate how different expense ratios impact long-term outcomes for index fund investing with a clear, relatable example. We’ll assume two investors, Alex and Bailey, each invest $10,000 in an S&P 500 index fund with an average annual return of 8% (before fees) over 30 years. The only difference is the expense ratio: Alex’s fund charges 0.04% (like a low-cost Vanguard or Fidelity fund), while Bailey’s fund charges 0.75% (like some higher-cost actively managed or specialty index funds). Both reinvest dividends, and we’ll use compound interest to calculate outcomes.

The Setup

• Initial Investment: $10,000

• Time Horizon: 30 years

• Annual Return (before fees): 8%

• Alex’s Expense Ratio: 0.04% (net return: 7.96%)

• Bailey’s Expense Ratio: 0.75% (net return: 7.25%)

The Math

Using the compound interest formula, ( A = P \times (1 + r)^n ), where: - ( A ) = final amount - ( P ) = principal ($10,000) - ( r ) = annual net return (as a decimal) - ( n ) = number of years

Alex’s Outcome (0.04% Expense Ratio)

• Net return: 7.96% (0.0796)

• ( A = 10,000 \times (1 + 0.0796)^{30} )

• ( A \approx 10,000 \times 10.006 \approx $100,060 )

Bailey’s Outcome (0.75% Expense Ratio)

• Net return: 7.25% (0.0725)

• ( A = 10,000 \times (1 + 0.0725)^{30} )

• ( A \approx 10,000 \times 7.985 \approx $79,850 )

The Difference

• Alex’s Portfolio: $100,060

• Bailey’s Portfolio: $79,850

• Difference: $100,060 - $79,850 = $20,210

That 0.71% difference in expense ratios cost Bailey $20,210 over 30 years!

Expense ratios seem small, but they’re like termites eating away at your returns. A low-cost index fund (0.04%-0.1%) maximizes your wealth, while higher fees (0.5%-1%) can quietly erode your gains. For passive income seekers, this means less money for dividends or withdrawals down the road.

Take Home

Time is your superpower. Reinvesting dividends and holding for the long haul can transform modest yields into a snowball of cash flow. Thanks to compounding, your investment grows, and so does your passive income potential. Over decades, the yield on cost can climb significantly.

Index funds aren’t a magic bullet, but they’re a darn good cheat code for building wealth without micromanaging your portfolio. They offer low costs, diversification, and a slow-but-steady path to passive income through dividends and capital gains. Sure, the initial yields are modest, and market dips can test your patience, but time and compounding are your secret weapons. I use index fund investing as a part of my passive income portfolio to accomplish these purposes.

Ready to unlock financial freedom? Your future self, sipping that piña colada, will thank you. Head to CheatcodeWealth.com for more tips, and let’s keep cracking the code to financial independence together!