3 Reasons You Should Be Investing In Index Funds
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Index funds are a popular way to invest your money.
In my opinion, they should have a seat in the portfolio table of every investor.
They play a fundamental role in building your wealth and making your money work for you.
These reasons explain why.
Table of Contents
What Are Index Funds
Index funds are a type of mutual fund that tracks a particular market index made up of shares or bonds.
The first time I read that statement I had no idea what it meant.
So I’ll break down the components.
Market Index: An index is a form of measurement.
In the investing world, it measures the performance of shares and/or bonds.
Shares: A ‘share’ is a piece of ownership in a company you’d invest in by buying that share.
Putting these two together, in the US there is the S&P 500.
This is an index used to measure the performance of the 500 largest US companies that you can buy shares in.
Mutual Fund: A collection of many shares in one basket that many investors put their money in.
In essence, an index fund is a collection of many shares in one basket.
These shares are based on the index that the fund is built to replicate.
So an S&P 500 index fund will be a collection of all the 500 shares in the S&P 500 market index, in one basket.
When you start investing in index funds, you’re investing in a number of shares at once.
Why Invest In Index Funds
We invest money so it can make us more money through that investment.
There are many reasons people invest.
Ours is Financial Independence.
By making our money grow we’re aiming to reach financial freedom.
Freedom from needing a job by having enough money to live without a job.
Index funds are one of the vehicles we’re using to get us there.
Having a clear picture of why you want to invest your money is key.
Especially with index fund investing.
For most people, it’s to build wealth.
The Simple Path To Wealth essentially says index funds are the way to do it.
3 Reasons To Invest In Index Funds
These reason will teach you more about index funds and how they work.
By understanding that, you will certainly appreciate their role in your portfolio.
And the penny may drop to why many of us are loyal index fund investors.
These 3 reasons to invest in index funds aren’t exhaustive.
There are plenty of other reasons however I won’t get into them in this post.
But these 3 are what I’d consider the cornerstone of index funds.
Index Funds Give You Instant Diversification
One of the best things about index funds is you’ll instantly have diversification.
Using the S&P 500 index fund as an example, that’s 500 companies in your portfolio.
This index fund would track the overall performance of all 500 companies.
If 150 companies make a loss or a drop in the value of their shares, you’d still have 350 keeping your fund in the green.
Why Diversification Matters
Imagine if you’d invested all your money in the travel industry just before Covid-19.
You would’ve seen your investments diminish due to the global lockdown.
The S&P 500 is split: 27% in Tech, 13% in Healthcare, 11% in Financials and more.
Diversification isn’t just about having a lot of shares.
It includes being invested in multiple industries and geographic locations.
There are many other types of index funds to invest in.
The FTSE Global All Cap Index Fund has almost 7000 shares within it.
56% in North America, 16% in Europe and so on.
Diversified by industry and geographical location.
Diversification limits your risk as an investor.
The risk of being invested in one company, one industry or one country.
If that company, industry or country fails financially, so do your investments.
See the power of index funds yet?
Index Funds Are A Passive Investing Strategy
There are two sides to this coin.
Index funds are passive investments. Index funds are great for passive investors.
Passive Investments
There are two types of funds. Active and passive.
Active funds are where the fund manager buys and sells shares within the fund throughout its lifetime.
They do this to replace the low performing shares with better ones.
If the market index is going down they attempt to keep the fund in the green.
This is known as trying to beat the market.
Their goal is to bring better returns than the index, like the S&P 500 index.
Index funds are the heart of passive investing.
They simply track the performance of all companies and give the average return of all of them.
They don’t sell underperforming shares to replace them with better performers.
Index funds don’t try to beat the market, they simply track and follow it.
If the S&P 500 goes up, so does the index fund.
If it goes down, so does the index fund.
Active vs Passive
Surely active investing sounds better, right?!
On paper, absolutely.
Professional analysts and fund managers take care of your investments for you.
They aim to generate the best returns you’ll ever see.
So what’s the problem?
The Little Book of Common Sense Investing breaks this down nicely.
John Bogle explains that no one in the investing world has a crystal ball.
The investing experts don’t know the future.
They don’t know which companies are going to outperform the market.
They may replace bad apples with future bad apples.
Research shows few active funds actually outperform the market.
The majority fail to do so which means low returns on your investments.
Secondly, it’s expensive.
Because there’s a fund manager actively managing a fund, they charge higher fees.
They may even beat the market, but after fees are deducted you’d be no better off.
More on this shortly.
Passive Investors
The other side of the coin is the passive investor.
Passive investors invest for the long haul.
They buy shares today and own them for a long period before selling them.
This can be as long as 30 or 40 years. Your whole adult life.
As a passive investor, I simply buy and hold. And hold some more.
I’m happy to accept the market returns on the basis that active funds rarely beat the market.
I don’t need to actively manage my portfolio every day.
Nor do I need a team of analysts to try and beat the market.
I simply invest every single month into the same fund and…go about my life.
Index Funds Have Lower Fees
In the investing world, there are a number of fees investors get charged.
One such fee is called the Expense Ratio, or the Ongoing Cost Fee.
This is the fee for managing a fund charged by the fund manager.
Earlier I told you that active funds are expensive, this is why.
Investment Fees
Active funds typically charge between 1-3% per year.
Doesn’t sound like much but index funds can be as low as 0.05%.
If you have £1,000 invested in an active fund, you’d pay £10-£30.
In an index fund, you’d pay as low as 50 pence.
With £50,000 invested this would be £500-£1,500 in an active fund.
But it’s as low as £25 in an index fund.
Investment Fees Over 30 Years
Let’s say you invested £10,000 upfront and £500 monthly for 30 years.
If invested in an active fund with 1% annual fee, you’d have just over £780,000 after 30 years.
If invested in an index fund with 0.2% annual fee, you’d have just over £913,000 after 30 years.
The £133,000 difference is all fees!
This calculation assumes both earn the same return.
But the point remains.
Given that active funds generally underperform an index fund, why pay the higher fees?
Index funds are cheaper because the are passive. No active management is needed.
You can also invest with as little as £1 in index funds.
We use Trading 212, Fidelity and Vanguard for our investments.
All great platforms for index fund investors.
3 Reasons You Should Invest In Index Funds
In summary, the reasons you should be investing in index funds are:
- Instant diversification
- Passive investment strategy
- Lower Costs
As mentioned earlier, there are so many other reasons for index funds.
They are a great option for most investors whether you’re a beginner or a pro.
But the question for you is, are you a believer in index funds or are you trying to beat the market?
Take Action
Start your investing journey if you haven’t yet. Even if it’s reading books.
Review your index fund portfolio if you have one. Does it fit the bill with how I’ve described them above?
Share this to others if you found value in it and feel others should too.
Check out our Ultimate Money Plan to get in control of your money and smash your financial goals
Let us know how you’re getting along by getting in touch with us, we’d love to hear from you
Knowledge is powerless without action
So take action, and take care
Thando