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. Continue reading