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.
Stock markets have a vast selection of stocks and bonds that can be invested in and before deciding what to invest in, understanding the main differences between stocks and bonds well is absolutely key if you consider getting in the stock market. Investors can decide whether they want to invest in just shares, just bonds or whether to create their own mix of stocks and bonds. With time, many furthermore decide to slowly reallocate their investments, so even if you start with a certain percentage shares and bonds, this needn’t stay as such for the rest of your investment life.
Here we’ll look at the main differences between shares and bonds from an investor’s point of view and how they both offer different advantages and disadvantages.
Share prices vary more day-to-day but also over long periods of time: their value can increase or decrease fast.
Bonds are generally more price solid and fluctuate less over time and at a much slower pace than shares.
Here starts a new part of our 100 steps to financial independence, with this being the first step in a mini-series on investing.
If you are serious about money, it is worth understanding more about the stock market and at least get a basic idea of what it is and how it works, before you decide for yourself whether investing will be something you would like to start doing. Investing is often a long-term decision and depending on the risks you are willing to take, you might or might not feel that investing is the right thing to do for you.
Let’s start with one of the key components of the stock market: shares (also known as stocks) and find out what they are, why they exist and how they make or lose us money.