Step 52: Investing through Index Funds / ETFs

Step 52 of the 100 steps to Financial Independence: Investing through Index Funds
Step 52: Investing through Index Funds

It is now time for an introduction to the third main way of investing. As you were able to appreciate in step 50 on handpicking stocks and step 51 on mutual / collective funds, both ways have some very strong advantages, most notably the possibility of making lots of money on the stock market. Yet the opposite unfortunately is also the case and rather more likely than the first scenario… As we’ll see below, the third way of investing aims to find a middle ground between making money on the market and avoiding losses.

Index investing – an overview

Imagine looking at a long list of all the stocks and shares in a particular market – an index (such as the S&P 500) – and buying shares of every single company in that index in the same proportion as their relative size in the market. By buying all the shares of all the companies in the index, you basically copy the market and therefore will almost exactly get the same returns as the market average.  (It will normally be just a fraction below due to the small fees you pay). If the index goes up by 8% your return will be around 7.8%, if it goes up by 13% your returns will be around 12.8% etc. That’s what index investing does. Sounds simple and indeed it is simple.

Of course as a small investor you’ll never have enough money to buy shares of all the companies in the index, which is why index investing – like with mutual funds – pools money of different investors together in order to increase buying power.

In index investing, no predictions are made in terms of which companies will be doing well and which shares to buy and which ones to sell. The shares are simply bought or sold depending on pre-defined rules. If a company doesn’t perform well and gets taken out of the index, then so will those shares – they will be replaced by those of new companies entering the index. Index investing is also known as “passive investing” and is characterised by a buy-and-hold strategy. You don’t try to beat the market, or to sell just before a recession, you just sit and wait. Passive investing is therefore especially interesting for long-term investors.

There are no fund managers assigned to the funds, making this way of investing a lot cheaper. The absence of continuous trading furthermore avoids load fees, excessive taxes and other fees paid in many mutual funds. Portfolios become very diversified, which leads to risk being spread, so that even if one industry doesn’t perform well one year, their lower results can be compensated by the higher returns of an industry that performed better.

The biggest disadvantage of index funds? You’ll never beat the market. You’ll always get the average return, nothing more and nothing less. It is a relatively safe way to invest (Though you can still lose a big chunk of your money if the market crashes!) and though you’ll never outperform, you’ll never underperform either.

Index investing vs ETFs

Whereas both index investing and investing in ETFs are types of passive investing by following the market, there are certain differences between the two. One of the main the main differences being that ETFs can be traded almost the entire day, whereas in index investing trading often only happens between once a week to maximum twice a day. The advantage of being able to trade pretty much all day when the market is open means that you can play the market more, for example buying almost instantly when prices drop. The potential danger with ETFs is that it can make investing active again, with investors trying to trade continuously instead of passively letting their portfolio grow without trying to beat the market. Costs are even lower than with index investing however, which makes them more interesting. But ETFs are not real shares, but a form of derivative trading, where in reality you predict what the market is going to do and buy artificial shares. This sounds scary maybe, but there are many who believe that ETFs are the future and ETFs are becoming more popular. ETFs are created by investment banks however so remember that they can go bust. Make sure their ETFs are backed up by real shares as otherwise you are left with nothing.

In short, the advantages and disadvantages of passive investing are:

Advantages:

  • the only decision you need to make is which market(s) to follow and how much of your portfolio you want to put into shares and how much into bonds . You don’t need to make individual decisions about companies or know anything about them.
  • Companies that go bust just get replaced by new companies, so you never lose all of your money.
  • Costs are very low (think 0,25% a year and maybe a small buying fee) so you don’t lose money on paying fund managers, commissions on selling and buying etc.
  • You’ll always get more or less the market average return.
  • No research is done and no fees need to be paid to fund this research.
  • You only pay taxes on dividend and / or interest payments a year and the very small percentage of capital gains of shares that were sold, instead of paying taxes on the continuous gains made in mutual fund investing.
  • You have stocks of the entire market, not just a segment, meaning you’ll have a very diversified portfolio, ensuring a decent spreading of the risk.

Disadvantages:

  • You will never beat the market. You maximum return will be the market’s average. (Remember that this is still a lot better than what many mutual funds achieve though!).
  • You might end up with shares you don’t want from a moral point of view or because you already know the companies are unlikely to keep performing well. You have no say over the stocks or bonds you get.
  • In the case of index investing, trading often only happens at set moments, so you can’t have instant access to or say over your assets.

Step 52 – Investing through Index Funds / ETFs – in detail

  • Investigate what is available to you in your country if you were to open an index investing account. Do internet searches and look for the following information on various brokers:
    • Minimum amount when paying a lump sum
    • Minimum monthly amount if making monthly contributions
    • Yearly fees
    • Buying and selling fees
    • Tax advantages offered
    • Types of funds (both stocks and shares) available
    • Average performance of funds over last few years (although this should pretty much reflect the corresponding market averages).
  • Compare various brokers to see what would be most suitable for your situation.
  • Many financial bloggers share their experiences on brokers as well, so find some established bloggers from your country and see what their experience is with various brokers. That said, make sure to make your own judgement call.

There you have it, an introduction to the three main ways of investing. Now whether you decide to invest or not… that is completely up to you. I can give you one last step on some pointers, but after that you’ll need to make up your mind yourself. You can make a decent amount of money by investing, but of course, nothing is certain and whether you might lose your money over the short-term or even long-term nobody can predict.

As said before, this was an Introduction. These past few steps were nothing more than the tip of the iceberg of investing. If you are serious about investing, you’ll want to read more about it in greater detail, so make sure to find additional information before you actually start investing.

Read more about my 100 steps mission to financial independence or simply decide to take control today and join us on our step-by-step quest on how to make your finances work for you, starting with step 1.

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