Easy Peasy Investing: Index Funds

So you’ve heard investing is risky. You’ve heard you need quite a lot of money to get started. You’ve heard it’s a lot like gambling. And guess what? You’re right. After reading The Little Book of Common Sense Investing by John C Bogle, I present a solution so you can take a slice of the investing cake without risking your money.

Types of investing

In investing there are two types of investors: Fundamental and Technical. Technical investors buy and sell on price and market sentiment, and use different techniques for day trading. They rely on the timing of the market, choosing when to sell and buy.

Fundamental investors are investors who invest in a company because they believe in its foundations. They review the financial statements, they analyse the business plan and once they invest, it’s for the long term. They rely on the time of the market; the longer the better.

The technical investor is an expert with numbers, who believes that through different mathematical processes they can predict whether a stock price will go up or down. It’s quite risky because the market is volatile and very hard to predict short-term.

The fundamental investor is an expert in research. They spend hours and hours reviewing the financial statements and evaluating whether this company is worth investing in. There is still high risk because the companies chosen can always under perform and sometimes unpredictable things happen.

In both cases, expertise is needed. So what should YOU do? You don’t have the time, money or energy to become an expert. What can you do instead? Give over your money and let someone else handle it for you: mutual funds and index funds.

trader investor index funds

Image source: stox365

A what fund?

A mutual fund is a compilation of stocks chosen by a fund manager; a human who chooses the stocks to invest in. This manager is an expert, and could be either a fundamental or a technical investor. You give £5000 to your fund manager and he or she is then in charge of investing in companies of their choice with your money, which they then take a percentage of. Because your fund manager is an expert, you trust that they will increase your returns and that your £5000 will turn into a higher number than before.

We then have the index fund. The index fund is basically a mutual fund, but instead, you own all the stocks. Your portfolio owns a tiny percentage of all the stocks in the market, whether it’s the FTSE of the S&P 500. A computer manages the percentage you own: when a stock value increases, so does your percentage. This means no brokerage and trading costs. Because overall the market will perform, you always get guaranteed returns. This means you can put your money in and not touch it for 50 years.

Both sound pretty nice and simple, right? Just give away some money, and every year you’ll have some more. Although true, there are some major differences between mutual and index funds: cost and performance.

mutual funds index funds

Image source: RothIRA.com

$$$

In a mutual fund, you need to pay commissions. High commissions. You need to pay the fund manager, the trading, the sales charges, the portfolio turnover, brokerage commissions, bid ask spreads and market impact costs. Yes, that’s a lot. Bogle proves in his book that an annual return of 7% in your portfolio comes down to ONLY 1.4% after costs. That’s 5.6% less that DISAPPEARS. It’s heat-breaking for investors and honestly a huge rip off.

But there is good news. Remember how index funds are controlled by a computer? Remember how there is no trading and no brokerage costs? Index funds can charge a commission of as little as 0.22%, meaning you practically get your 7% each year. It’s great!

In the mutual fund, it’s the middle man that wins. In the index fund, it’s the investor who wins.

cost index funds

Image source: SomebodyShoulda.com

Performance

With a mutual fund, we are relying on a human to choose the correct stocks which will give us returns. A human makes errors and sadly cannot predict very accurately. Bogle explains how, on average, a fund manager lasts 5 years! Yes, you read that right. In 30 years from 1970 to 2000, 80% of the mutual funds went out of business! How on Earth are we supposed to make long-term investments? And how do we know how to pick the 20% side? At this point, it’s purely chance.

With an index fund, we are relying on the stock market itself. There will always be returns and no one will be picking stocks while relying on human expertise. Because of this, Bogle explains that on average, the index fund produces 2% more returns than the mutual fund.

To paraphrase Roger Martin‘s ideas in his book ‘Fixing the Game‘: Investing in a mutual fund means investing in the market of expectations, a market which is essentially based on human emotion and therefore unreliable. Investing in an index fund means investing in the real business market, where real businesses earn real money and therefore where the investor will receive their returns.

index funds

Image source: Enterprising Investor

Not convinced yet?

All these are direct quotes from ‘The Little Book of Common Sense Investing’:

‘The mutual fund industry is a colossal failure… resulting from its systematic exploitation of individual investors… as funds extract enormous sums from investors in exchange for providing a shocking disservance’ (David Swensen, chief investment officer of Yale University)

‘Funds chosen by advisers earned 40% less than an index fund.’ (New York Times contest)

‘The odds of a fund outperforming for 15 years consecutively are 1 in 223,000, and at 1 in 31 million over 21 years.’ (Michael J. Mauboussin, chief market strategist at Legg Mason.’

Even Warren Buffet! ‘By periodically investing in an index fund, the know-nothing investor can actually out-perform most investment professionals’

And many, many more.

Get started

There is more than enough proof here that index funds are the way to go. So what now? Start thinking about investing. I would suggest actually reading Bogle’s book ‘The Little Book of Common Sense Investing’. Then start researching where you can open an index fund in your country/city. Compare commission prices and choose the index fund which works best for you. Educate yourself and explore. Remember that index funds mean low risk and a steady return each year. You have nothing to lose!

Good luck! And feel free to drop me a message if you have any questions or want to tell me how you’re doing!

 

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