Being a successful investor is often considered as beating the overall market return. But what if you are happy with the market return? What if you don’t want to dedicate your free time to reading financial reports, CEO letters and want to avoid risk as much as possible?
If so, investing in an index fund might be the thing for you. Hang on, I will cover everything you need to know.
” By periodically investing in an index fund, the know-nothing investors can actually outperform most investment professionals.” ~ Warren Buffett
Here’s what you should know before deciding to invest in an index.
What is an index?
An index is an indicator of a market or refers to a specific segment of it. So indexes are not physical portfolios but rather a hypothetical bundle of stocks based on certain agreed on properties. It could, for example, be the weighted average of some specific stocks. An index often contains the best-performing companies. One of the best-known indexes is the S&P500, covering the 500 largest US-based companies.
Where are indexes used for?
Indexes are used to measure the performance of specific segments of the stock market. Sometimes, the performance of individual companies is compared to the index. For example, someone with investments in individual companies will often compare the returns of the investment to the S&P500 index as this is seen as an accurate representation of the “whole US stock market”.
Investors who own individual stocks often want their returns to be higher than the “overall market” (S&P 500) because owning individual stocks is considered to be a lot riskier than an investment in an index such as the S&P 500.
Getting returns that exceed those achieved by the S&P 500 is often referred to as “beating the market”, which is the goal of many investors.
A few examples of well-known indexes are:
- S&P500: Tracks the performance of the 500 biggest US-based companies.
- The Dow-Jones Industrial Average: Currently contains 30 companies of multiple industries excluding transportation and utilities. The Dow Jones Industrial Average is calculated in a different way than the usual “Market-Capitalization-Weighted” approach.
- All-World index: Tracks 47 countries and a total of 2700 stocks.
When you know that most professional fund managers don’t succeed in beating the market, investing in an index can be very attractive.
How to invest in an index?
Let’s first cover what type of securities can be used to invest in an index. Then we will look at how you have to invest in order to capture the average market return. This is important to avoid buying when prices are high and selling when prices are low.
ETF and index fund
There are two common ways to invest in an index fund. You can either buy an ETF (Exchange-Traded Fund) or you can invest in what is referred to as an index fund.
Both an ETF and an index fund will track a specific index. The biggest difference between the two is that an ETF is traded like stocks and thus also has volatility like stocks have during the trading hours on the stock market.
An index fund, on the other hand, is more like a mutual fund and is not bought or sold at a market price but rather at its net asset value. Index funds can also only be sold at the end of the day.
Both an index fund and an ETF are not actively managed by a fund manager and are therefore considered to be very low cost and also less vulnerable for errors.
The difference between ETF’s and Index funds is well explained in depth here.
When to buy an index fund or ETF?
In order to capture the average market return, we are going to use the “Dollar-Cost Averaging” strategy. This is a strategy suggested by Benjamin Graham in his famous book “The Intelligent Investor”. Benjamin Graham is considered the “father of value investing” and was the former teacher of Warren Buffett.
I guess you could say this guy knew a thing or two about investing.
So this is what it is all about:
The “Dollar-Cost Averaging” Strategy suggests that one should invest the same amount of money at a regular and constant periodic interval. Over time, this method will average out the fluctuations of the market.
If you buy one unit of an ETF at the following prices:
Month 1: $10
Month 2: $20
Month 3: $30
Month 4: $8
Average cost per unit = $17
Because no-one knows for sure when a market will boom or when it will go into a recession, timing the market has been proven to be a bad strategy. If the investor, in this case, had tried to time the market, chances are that he would have bought at a higher price than $17.
” The stock market is a device for transferring money from the impatient to the patient. ” ~ Warren Buffett
The “Dollar-Cost Averaging” strategy, when used for investing in a high-quality index, is often considered as a low-risk strategy.
Please note that this strategy will only be useful for long-term investments. So, if you are not sure whether or not you can go without that money for at least 5 years, you shouldn’t use this method to invest.
To use this strategy, there are 3 really important rules to follow in order for you to be successful with your investment.
- Invest Long-term
- Invest at a regular interval
- Invest the same amount (you can adjust this amount by the rate of inflation in order to keep the value of the investment the same)
On the graph below we can see the results of an investment in the S&P 500 you would get if you were perfectly timing the market (which is extremely unlikely) vs when you use the “Dollar-Cost Averaging” method.
Is an investment in an index fund safe?
In general, index funds are seen as safe investments. The reason for this is that you buy a small portion of many companies. So by investing in an index fund, your money is spread across multiple industries, companies and sometimes even countries. When some of those companies are going through rough times, it usually is compensated by other companies in the index who flourish.
However, there is still some risk that you buy in at the height of the market. Therefore we suggested using the “Dollar-Cost Averaging” method.
Passive investing can be lucrative for long-term investing. The returns are average while reducing exposure to risk and market conditions. It’s a proven way to invest successfully.
If you do want to learn more about investing, here are some books to consider:
- The Intelligent Investor ~ Benjamin Graham
- The Little Book of Common Sense Investing ~ John C. Bogle
- The Essays of Warren Buffett ~ Warren Buffett
*Disclaimer: The content on this page is made in good faith and I believe it is accurate. However, it should only be considered as informational and not for making financial decisions.