This post may contain affiliate links and we may get paid a small commission if you click on a link. Please read our disclosure.
The Humble Guide To Passive Investing – Episode 2 – Index Fund Investing And The Simple Path To Wealth
Index fund investing has risen hugely in popularity over the last number of years,
with the likes of Warren Buffett championing it.
In fact, in his 2014 shareholder letter, Buffett recommended The Little Book Of Common Sense Investing (by John Bogle) over advice from most financial advisers.
John Bogle is the father of index fund investing.
He’s also the founder of Vanguard, which is one of the most respected and successful companies in the investment world.
Index fund investing has become so popular that over 20% of all investment in the US equity markets is believed to be through an index fund.
Most people consider investing to be quite complex and usually have no idea where to start.
My personal approach to investing is to keep things simple, and index fund investing is one major way of doing this.
This simple approach is also what Jim Collins writes about in his highly recommended book called The Simple Path To Wealth.
When you invest through the stock markets, you’re pretty much buying assets that you will ultimately own directly or indirectly.
You can either buy a piece through stock picking or you can buy into a basket of stocks themselves i.e. funds.
In my opinion, the only people who should really be buying individual companies are:
- Those who understand how to value companies, and/or
- The sophisticated or rich investor
Warren Buffet fits into all of the above, and as such can afford the time and resources necessary to buy specific companies as he does through Berkshire Hathaway.
Although he rightfully promotes public index funds, he invests by creating his own private fund.
For everyone else, the next best option via public Index Funds is very good.
[redbar]It is important to remember that whether you buy into stocks directly or indirectly, what you’re really buying into is an existing business.[/redbar]
That business will have employees (often in the thousands), with livelihoods just like you do.
When you buy into that stock or basket of stocks, they’re all essentially working for you.
Thinking of this more deeply, if you’re seeking Financial Independence and investing through the stock market, then you potentially have tens of thousands of people (in different markets) working very hard for you to achieve freedom one day.
I am sharing this aspect of investing in order to make this activity real for you. It is ultimately alot more than just logging into an app and executing a buy or sell order.
Another reason I mention this is so that you can realise that your success through the stock market is only achieved by the hard work of others.
Although you had to position yourself ofcourse to be helped. So when you see success, remember others in your own way.
Related: The Power Of Generosity and Why It Pays
Given the popularity of index funds, it is important to understand what they are, why you should consider investing and what the risks are.
What is an Index?
Before diving into what an index fund is, it is worth explaining what the word “index” actually means.
An index is pretty much a sample of the market or a way of segmenting the stock market.
This sample is selected by people (e.g. a committee) who come up with the rules of what individual holdings should be included.
[yellowbar]In a way, the index itself doesn’t actually exist! I.e. it’s an idea. It’s important to note that the index is just a list of stocks! Anyone can create one.[/yellowbar]
Examples of an index include the FTSE 100 Index or the S&P 500, which are a collection of the largest 100 and 500 companies in the UK and US Stock markets respectively.
Indexes help investors track the performance of the stock market.
E.g. Movements in the 100 largest companies in the UK (FTSE 100) gives an indication of what is going on in the stock market and even the economy.
Given indexes are pretty much a list of stocks, it means there are good, bad and mediocre indexes (i.e. lists).
The FTSE 100 and S&P 500 are popular because of the reputation of the company that puts out the index (i.e. compiles the list).
For example, the S&P 500 and Dow are owned by a reputable company called S&P Dow Jones Indices. The FTSE (Financial Times Stock Exchange) 100 Index is owned by a reputable company called FTSE Group.
What is an Index Fund?
An index fund is, therefore, a basket of individual holdings (e.g. stocks or bonds) i.e. mutual fund that aims to track a particular index.
That fund itself is a pooled structure (i.e. pot of money).
So if you buy the S&P 500 index fund, you’re buying a portfolio of stocks.
However, it’s held in a pooled structure with a portfolio manager who is responsible for tracking the index i.e. replicating the results of the S&P 500 index.
Investing in an index fund makes the assumption that you’re are not trying to beat the market.
This is counterintuitive because human beings naturally think they can beat the market, hence why they select individual stocks themselves.
Index investing is a passive form of investing, which goes against the approach of active fund management.
The latter involves a manager who actively (and expensively!) picks stocks believing he/she can outperform the stock market.
What are the Advantages of Index Fund Investing?
One of the biggest advantages of an index fund by far is costs. Investing in an index fund requires little or no upfront costs. Ongoing annual costs are typically anything from 0.04% to 0.25%.
However, an active manager would typically charge you 5% upfront commission, followed by an annual management charge of around 2%.
Costs play a huge role in the returns on your money over time and should not be underestimated. These high fees are what keep the industry afloat!
One way to know you're investing in an index fund is to look at the Total Expense Ratio (TER). It would be very small relatively if it's an index fund.
Related: Understanding Investment Fees and Why It Matters
Investing in an index fund means that you own a piece of every company in the index.
As such you benefit from diversification away from specific risk by nature.
3. Self Cleansing
Think about it, over time, the makeup of the major indexes such as the FTSE100 or S&P500 change.
This is usually due to performance I.e. only the companies with the largest market capitalisations remain on the index.
This also means that if companies go bust for one reason or another, they simply drop off the index.
You end up holding the best companies and with the best people working for you.
This self-cleansing work is done for you essentially if you buy the index, rather than having to do this yourself through stock picking.
4. Emotional Stability
Index investing removes the emotional and psychological aspects of investing.
If you had a portfolio of 10 to 20 stock and 2 or 3 of them were performing very badly due to an industry shock such as the oil crisis, you’d likely be considering selling.
However, investing in an index funds removes your short-term focus as you’ll not see these bleeps play out explicitly in the price of the index fund.
You’re therefore more likely to forget your investment (as you’re meant to) and let it work for you over the long term.
5. Anyone Can Do This
You don’t need to be good at maths or understand how compounding or diversification works to get involved here.
All you need to do is to get your act in order and get involved, investing consistently and over time.
6. Enjoy Good Returns
Index fund investing gives everyone the opportunity to get there share of stock marketing returns.
These returns come about because over time a broad-based index fund typically returns on average about 7% gross.
In addition, the super low cost of these index funds means that your net returns can build up and compound over time.
7. Important Lever For Your Financial Independence
Index fund investing is an important lever if you’re working towards your Financial Independence.
[redbar]Whether you’re in your wealth accumulation or preservation stages, you’d ultimately want to keep costs low whilst enjoying the best possible returns.[/redbar]
In working out how much money is enough for your Financial Independence and putting in place a suitable asset allocation, index funds will most certainly feature heavily as a path.
What Are The Downsides Of Index Fund Investing?
1. Market Risk
Although index fund investing removes “specific risk” associated with picking individual stocks, you’re inevitably exposed to market risk.
Market risk is simply the risk that the market as a whole may go up or do over time. This is inherent and there is no escaping it.
2. Not Ideal For The Really Rich Folks
People who are extremely wealthy don’t really invest through index funds because their problems are on a whole different level.
They typically have tax planning and succession issues to worry about. As such, they manage their money privately or through a major manager that can also offer the other services they require.
This problem is ofcourse not relevant to most people!
3. Sector and Industry Bias
Most index funds are not intelligently representative of different sectors and industries.
Indexes such as the S&P500 could be argued to be heavily weighted towards Financial and Tech companies.
How Do You Invest In An Index Fund?
Index funds take two main formats. You can do this either via a
- Tracker Fund or via
- an Exchange Traded Fund (ETF)
Both have the same aim, which is to track a given index.
Tracker funds were traditionally the name given to those that work like investment funds. ETFs are traded on stock exchanges like ordinary shares.
Both traditional tracker funds and ETFs keep costs ultra-low as there is no need for expensive fund managers who try to pick winners for you.
You can access these index funds through typical fund providers such as Vanguard, Hargreaves Lansdown The Share Centre etc.
An important point to make is that you should ideally buy these within a tax efficient vehicle such as an ISA or a SIPP, so you don’t pay capital gains tax.
How Do You Succeed Investing In Index Funds?
The key to succeeding here is as follows:
1. Start and Invest Consistently
Start investing as soon as you can and keep your investing consistent e.g. via a monthly direct debit.
This not only encourages you to keep investing, but you also benefit from time diversification i.e. dollar cost averaging.
2. Focus on broad-based high-quality index funds
Given there is a myriad of index funds out there, you want to choose one that is sufficiently broad-based.
The S&P500, for example, gives one exposure to 500 of the largest U.S. companies by market capitalisation.
These large companies typically have a global presence and earn income from various countries, offering diversification from that perspective too.
Do your research and do what you think works for you. The key is to keep it broad-based.
3. Have a very long-term view
Behavioural biases lead to people often buying high and selling low.
The more you can buy and forget, the better.
Warren Buffett summarises this quite well:
[yellowbar]“For investors as a whole, returns decrease as motion increases”[/yellowbar]
I recall reading about a study Fidelity conducted on how Fidelity account holders had performed over time.
The best performers were dead people, followed by the accounts of people who forgot they had an account at Fidelity.
Having a long-term view (25 to 50 years for example) could be game-changing not just for your life but generationally as you allow time for compounding to work.
4. Reinvest your dividends
Doing this automatically will add fuel to the compounding machine that is your portfolio.
5. Don’t sell when a crash happens
Stock market crashes are guaranteed events. If you believe and expect this, then it should stop you trying to time the market.
What is more important than timing the market is time in the market.
Instead, what to do in the event of a crash is to buy more units cheaply.
I’ll paraphrase John Bogle from his book The Little Book Of Common Sense Investing :
The way to wealth for those in the investing business is to persuade their clients, “Don’t just stand there. Do Something”. I.e. Go stock picking.
But the way to wealth for their clients in the aggregate should be the opposite, “Don’t do something. Just stand there”. I.e. Ride the index and let time work!
Index fund investing and the passive movement is here to stay and there will continue to be a relentless push against it from the industry.
You, however, now know what to do and how to remove complexity and demystify stock market investing.
The question is, will you actually pull this lever as you work towards your Financial Independence?
If you want the “RoadMap To Financial Independence”, then subscribe below. I have put together a thoroughly practical course on Teachable that anyone anywhere in the world can use to achieve Financial Independence:
Plot Your Escape! Choose Financial Independence
Adam Peacock says
Hi, I’m looking at getting started with an index fund investment (probably through Vanguard). Just to clarify in my mind, each year a dividend may be paid out. So, does this mean you receive an income which is a percentage of your investment. So, if 7% on £1000, you could receive £70? However, another option is to reinvest year on year so that over time you can receive a much higher amount?
Can you also pull out the money you have put in at some point (the £1000 plus the interest?)
I would like to invest £1000 into something low risk (as a beginner) and possibly pay in £100 a month as well on top. Presumably you can add this £100 a month into the same index fund?
Great stuff! It’s been a fear of mine looking in to all of this but I think I am gaining some understanding now. I want to retire early (I’m 32 and would love to be completely free of ‘having’ to work by my early to mid 50s).