I’ve touched on the concept of index funds in an earlier post but thought it would be helpful to delve a little bit deeper into the subject of index funds.
For most people, index funds will form the basic foundation of their investment portfolio.
The great thing about index funds is that you don’t have to be a finance whizz to understand or invest in them. Index funds provide a cheap, reliable, and simple form of investment.
This makes index funds more accessible than some other forms of investments. Happy days.
What is an index?
Before trying to understand what an index fund is, it makes sense to understand what an “index” actually is.
An index is simply a way to categorise businesses in a list. Just like at the back of a book you might find an index which simply lists useful information, an index in business terms is basically just a list of companies.
Categorising companies into an index just makes it easier to measure and track performance.
Some of the most popular business indexes you might have even heard of in passing. Terms like S&P 500, Dow Jones Industrial Average, Nasdaq Composite, FTSE100.
They may sound complicated and technical, but these are all just names for big lists of companies.
Some indexes like the S&P 500 simply track the 500 best performing companies in America, and the FTSE 100 tracks the UK’s biggest 100 companies. Other indexes may track companies within a certain industry or geographical location.
Having an index (or list) just makes things easier to measure and that’s all you need to know.
What is an index fund?
Now we know that an index is nothing complicated or scary, let’s look at index funds.
An index fund simply picks one of these lists of companies and allows you to invest in the performance of the whole list.
What’s great about this is that an index can be very specific or very broad.
So with just one investment, you can own a small piece of lots of different companies across lots of different industries.
Index funds are cheaper than other forms of investment because they’re not actively managed. This means that there’s no one hand picking or selecting the companies in an index fund, it’s simply a list. If it is an index tracking the top companies in a country or industry, then the companies within a list might change. A new top-performing company might replace an old under-performing company, but there is no manager controlling this. It just happens automatically.
This is why index funds are sometimes referred to as “passive” investing.
Why doesn’t everyone invest in index funds?
Index funds are a simple, cheap form of investing that have often generated great returns over the last century. So why doesn’t everyone invest in index funds?
My best guess is lack of understanding. When I first came across the concept of index funds, I was looking everywhere for the catch. It all seemed so simple, and yet why had I never heard of them.
I was pretty skeptical when I first started learning about index funds because there just weren’t many downsides to them. If something doesn’t have many disadvantages, then why doesn’t everyone know about them? To be perfectly honest, I don’t know.
It might be that the complicated sounding names of certain indexes scare people off. Everyone can grasp the concept of buying shares in a company they’re familiar with, for example Disney. But because some indexes have names that people can’t relate too, they just presume it must be beyond their understanding.
With just a little bit of learning, index funds are easy to get your head around.
How to invest in index funds
Your ability to invest in index funds will depend on where you live.
In America there is a pretty good investment infrastructure for investing in index funds and you can do so quite easily and cheaply. Most Roth IRA’s or 401(k) plans will have the option to invest in index funds.
In the UK, investing in index funds is less commonplace but still quite popular. One of the best ways to invest in index funds in the UK is to set up a Stocks & Shares ISA and invest through that. Using a Stocks & Shares ISA will mean that you can invest up to £20,000 per year with no tax liability on any gains.
In somewhere like the Republic of Ireland however, the investment landscape is completely different. You can invest in index funds, but usually you will have to go through a broker or financial planner which can be expensive. Added to that expense is the fact that any potential gains from personally investing in index funds can be ridiculous, like 40% ridiculous. It is still possible and Degiro & Moneycube are good places to start.
So if you’re in the UK or US, make the most of your good fortune! If you live elsewhere, do some research into your ability to invest in index funds and also what the tax repercussions are. You might find that your money is best invested elsewhere to make it go further.
Where to invest in index funds
There are plenty of companies and platforms out there who you can use to begin investing in index funds.
Personally, I think it’s hard to beat Vanguard when it comes to value and service.undefined
I bang on about Vanguard a lot, but with good reason.
Vanguard have a low cost structure, so you get to keep more of your invested money. They also have great customer service and simple user interfaces on their websites. On top of all this, their founder Jack Bogle, created the first index funds in 1975 and pretty much wrote the book on cheap index fund investment.
How do index funds make money?
As the companies being tracked within an index fund make money, the value of that fund increases.
The best thing to do is choose an index fund where any gains are reinvested. Sometimes this is called an “accumulation” fund.
Doing this means that as your investment grows, any money made is invested back in to the fund, which means you can earn interest on your interest. So your money is making money… which is also making money!
Are index funds risky?
Risk aversion is something that scares a lot of people away from the idea of investing.
Things like recessions and economic downturns can definitely slow the growth of your investments but index funds are generally considered quite a low risk investing strategy.
In the long term, as long as you’re willing to ride out these bumpy periods, you should see your investment pot grow.
It’s important to remember that not all funds are created equal though. For example, investments in the US economy over the last century would have grown well, whereas investments in the Japanese economy might have remained stationary over the last 30 years because their economy has not been growing.
You have the ability to switch or move funds, so if yours starts underperforming you can always change things up. Bear in mind that you need to be patient and it can be counterproductive or expensive to keep switching funds continuously.
So it’s worthwhile doing a bit of research initially to pick an index fund that gives you good exposure to different markets in different countries and then sticking with it.
Although index funds are generally considered low risk, always remember that your capital is at risk and the value may drop as well as rise so it’s a good idea to play the long game.
Do you have to be a professional?
It’s this kind of sentiment that prevents regular people from thinking they can invest.
The beauty of index fund investment is that anyone can do it. Whereas buying individual stocks and trading can be very risky and should only be done if you really know what you’re doing, investing in index funds requires a minimal amount of technical knowledge and understanding.
Many people try and make investing inaccessible and complicated because they don’t like the idea that everyone can do it. They like to think they’re special. But we’re all special. And we all deserve to be wealthy!
Getting started with index funds
Index funds are a great gateway into the world of investing and provide a good solid building block for any investment portfolio.
I hope this guide has explained some of the basics around investing in index funds.
If you’d like to look further into index funds, here’s a great video reinforcing some basic explanations.
A good index fund to get started investing in is the S&P 500. It has a good history of positive returns and because America has some of the biggest companies in the world, it gives a good level of international exposure as many of these businesses trade globally.
Happy index fund investing!