Are you wanting to invest in index funds? I’ve broken down how to invest in index funds and why you should have them in your portfolio.
Investing plays a big part of building wealth and increasing your net worth.
In a nutshell, investing puts your money to work in places where it will grow at a faster rate than saving or cash would.
Having said that, it’s important to understand the fundamentals before you start investing.
I’d encourage you to take your time with investing. It can seem intimidating and scary at first but financial knowledge is the key.
Let’s go.
The Fundamentals To Invest In Index Funds
Investing is putting your money into an asset with the expectation to receive a return in the future. In other words, it’s putting your money where it can multiply and earn you more money.
You can invest in many many things but the four main assets to invest in are shares, bonds, property and commodities. Each asset type has a variety of strategies to choose from depending on your investing goals.
Investing in index funds is just one type of strategy of investing, and I absolutely love this strategy.
To understand the concept of index funds, let’s first go through the asset type of shares.
Shares
A share is literally a share of ownership in a company. Companies sell shares in an effort to raise money from you as an investor and in exchange you own a piece of the company.
They do this instead of going to a bank to borrow the money. Mainly due to desires to grow and expand the business further, which needs money.
Through this ownership there are 2 ways you’ll gain from it. The value of your shares could increase which allows you to sell them at a higher price than you bought them for. Or you receive a slice from the profits the company makes (paid as dividends).
How to invest in shares?
Shares are bought and sold from the Stock Market through a stock market broker.
Buying shares from one company can actually be a risky investment strategy. Why? Because you’re putting all your eggs in one basket.
If that company doesn’t do well in their business and ends up bankrupt, you could lose some or all of your money.
Bad performance will result in the value of the shares going down and/or no profits, which mean no dividend for you. (Simplification here but the point stands).
To succeed when investing in shares requires knowledge and expertise to analyse a company’s financials and strategy. You don’t just buy shares because you like the logo or you consume their products.
You invest in companies that you believe will give you a return on your money based on analysis and research.
What about those of us who don’t have this knowledge yet or quite frankly, don’t want to do that?
Well, that’s where funds come in.
What Is An Index Fund?
A fund is a collection of shares, like a box of many chocolates. A fund can have shares grouped by a specific industry, sizes of companies, or country of base operations.
Your investments will grow according to the combined performance of the shares that are in the fund as a whole.
Unlike shares, when you invest into a fund you’re buying into many companies within ONE fund.
Generally there are 2 types of funds, active and passive.
Active funds are where there’s a fund manager who actively picks which shares to include in the fund and which ones to sell from the fund. They do this with the aim to beat the market (more on the market later on).
Whereas, the passive fund automatically tracks the performance of the index that it is set to follow. Hence the name index funds.
An index is simply a measurement of the performance of a group of companies. There are many indexes such as the S&P 500 (US), the FTSE 100 (UK), and the DAX 30 (Germany).
For instance, the S&P 500 index measures the performance of the largest 500 companies in the US.
How do Index Funds work?
An index fund would buy all the shares in the same proportion as the index and then buy and sell to maintain the correct allocation between them.
The index fund doesn’t try to beat the market, it replicates it. This is why it’s considered a passive investment as you or a fund manager don’t buy and sell any shares. The fund is self-sufficient on it’s own.
An S&P 500 index fund would hold ALL 500 shares within the fund. However investing £500 does not mean you’ll own £1’s worth of shares from each company. The fund will replicate the weight of the companies in the S&P 500.
In the S&P 500, according to Investopedia, Microsoft is 6% of the weight of the index whereas Facebook is 2.1%. Your £500 will be divided to mirror the same, 6% will go to Microsoft and 2.1% to Facebook.
When you invest in index funds you instantly diversify your portfolio that holds many shares and not just one. Should 100 of the 500 companies not do well, you still have 400 companies keeping your portfolio in the green.
Unlike individual shares, you don’t have to do any company or stock analysis before you invest in index funds. You simply put money into the fund and..stay invested over time.
An index fund lets you own the entire market. Investing in ONE S&P 500 index fund gives you exposure to own ‘shares’ in all of America’s biggest companies.
Compounding Interest- The ONE Reason You Must Invest
One of the biggest reasons to invest is because of compounding interest.
“Compound interest is the eighth wonder of the world.
He who understands it, earns it. He who doesn’t, pays it”
Albert Einstein
This is simply, interest on top of interest.
If you invest £1,000 in an index fund with an average 8% return, it will end up with £1080 after one year. In year 2, you’d earn 8% of £1,080, meaning you’re earning interest in year 2 on top of the interest from year 1.
If you leave it for 5 years you’ll end up with £1,469.33. That’s 47% gains over 5 years due to compounding interest!
Keep in mind when it comes to investing, returns are NOT guaranteed.
Investing Risk – Will you lose your money?
Your investments can go up and down because of market fluctuations. This is why investing is a long term strategy to smooth out the highs and lows over time.
But fear not, on average the market has actually returned a positive annual rate of return of around 8%. That’s a lot better than savings accounts right!?
When I say the market, I’m talking about the S&P 500. Considering that Facebook, Apple, Google, Microsoft and Amazon are all in the S&P 500, it’s easy to see why.
To further illustrate the need for a long term investing mindset, let’s look at the S&P 500 performance in the short term.
The rate of return for 2017 was 19.4%, 2018 was -6.2%, 2019 was 28.9%, and June 2020 was 1.84%.
If you had invested money in 2016 and sold your investments in 2017, you would have gained the 19.4%. But if you had done the same for 2017 to 2018 you would have lost -6.2%.
But if you had invested in 2016 and sold in 2020, the average between those years is 11% per year. Holding your investments over time will smooth out the highs and lows.
Investing offers no guarantee that you will make money, but what do you gain from cash savings?
I’d love to say there’s no risk to invest in index funds but with money if there’s no risk there’s no reward.
Pensions and Investments
Before you go off and buy into a fund, you may already be invested in funds.
I’d first encourage you to check your pensions first. I know you did not expect to even think about pensions here, but let me explain.
A pension is a financial product that you put money into so that you can build up money for your retirement. And if you have one from your employer it’s likely that they are also putting money into your pension account too.
Your pensions are generally invested in what’s known as Lifestyle or Target Funds. They are mostly invested in shares in the early years, then switch to less riskier bonds as you approach retirement.
Your employer and the company that runs the pension scheme choose which investments your pensions have. Ask for the Key Investor Information Document (KiiD), or the Fund factsheet to find out.
These documents will outline to you what your pension is invested in and how your money is allocated towards the various elements of the fund. Some pensions give you the flexibility to restructure your pensions, although financial advice is strongly recommended.
Build Your Pension Portfolio
If you want more options and control, starting a personal pension gives you choice to build your own portfolio. You should also consider opening your own pension pot if you don’t have a work pension
You can get a private pension via a Self Invested Personal Pension (SIPP) or utilise the Lifetime ISA. Keep in mind you will have to monitor the investment’s performance and make any changes where necessary.
Take the time to learn how your pension is set up and the type of investments which are in it. You will realise that you already had investments in your name that you weren’t aware of.
And if you’ve had it for years you’ll appreciate the beauty of compounding interest when you see the calculations.
Did you know that pensions make up 42% of total household wealth in the UK.
If you don’t have a pension account with money going in every month, you’re seriously missing out!
How To Buy Index Funds
Step 1: Pick An Index
There are many indexes that you can pick for the fund to track. This can be the US, UK, or Total Stock Market Indexes. You’ll need to select the type of index that you’d like to invest in.
One of the common ones are the indexes that have a wide range of large companies with a long standing history. These give you greater exposure to a broad basket of many big company shares in one fund.
3 Indexes with a snippet of 5 companies within them:
You can invest in index funds for specific industries such as healthcare or technology, or index funds that only holds companies that pay dividends.
Take the time to look into which index you’d like to invest in and consider the risks.
Looking at the list of companies in the S&P 500 you can see that it’s less risky than the Nigerian or Brazilian index.
Less risk also means better stability. It’s highly likely that Amazon and Facebook will still be around in the next couple of years compared to companies in emerging markets.
On the flip side, more risk could see greater returns of your money as more risk means more money. The question is, how stable would that market be? You could make great returns and great losses.
So choose what you’re comfortable with according to your risk appetite.
Step 2- Choose an Index Fund
Once you have decided which index you’d like to invest in, the next step is to search for the index funds that invest into your chosen index.
Personally I love Vanguard index funds for many reasons. Largely because Vanguard is THE investment company for index funds. Index funds are their bread and butter!
Search the name of the index you’d like to track plus index funds on Google. Like “Toronto TSX Index Funds”. You may see the name of the index funds with the term ETF, which is the same thing.
Two Kinds of Index Funds
When choosing an index fund you’ll have 2 options: growth (also called accumulator) or income.
A growth index fund will reinvest the dividends and interest made back into the fund for the purpose of growing your investments. This is best for building wealth.
An income index fund will pay out the interest and dividends to your chosen bank account, which is considered as income. This is best for generating a source of passive income into your pocket.
Choose the one that best fits your investment goals and strategy. Keep in mind that compounding interest only works for the growth type of index fund.
You earn interest on interest if the interest stays IN the index fund.
Index Fund Fees
One major thing to watch out for are investing fees. With index funds being a passive form of investment they should have low fees. There’s no human behind them trading, they are automated.
The index fund fee is expressed as the ongoing costs, or the expense ratio. As a rule of thumb, keep under 0.5%, the lesser the better.
In a nutshell, if an index fund makes gains from the market of 10%, you will get 10% MINUS fees. So the lower the fees the more comes to your pocket.
Step 3- Choose A Platform to Invest Through
A platform is simply the wholesaler of the investments. Think of them the same as a car dealership. The cars are manufactured elsewhere then sold to you through dealerships.
Index funds are manufactured but the investment companies but they are also made available to the public via other companies. These companies are called platforms in this case.
The very first thing you want to check is that the platform you’re looking at, offers the funds that you want to invest in. Same as cars, dealerships will sell certain cars but not every single car that exists.
In other words find the platform that sells the car that you want.
What Investment Platforms Are There?
Personally I use Fidelity and they are good. Other great companies are Hargreaves Lansdown and Vanguard. Vanguard only offers their own index funds, so if you wanted something else look elsewhere.
Here you want to consider a wide range of things, such as customer service, ease of use, and whether they are app based or web based.
If you’re planning on investing every month then check what their minimum monthly payment amounts to invest are. Some are as low as £10 whilst others are £100 minimum per month.
You also want to check what their platform fees are that they’ll charge you for investing through their platform.
Step 4- Investment Accounts to Invest In Index Funds
There are 2 types of accounts that you can open.
The first one is a general investment account which is not shielded from tax, meaning any gains you make you’ll be liable to pay Capital Gains Tax.
The second option is through a tax-efficient account such as a Stocks & Shares ISA, Lifetime ISA, or the SIPP account. You won’t be liable to pay Capital Gains Tax on the money you make.
Keep in mind that with ISA’s the ISA allowance cuts across all ISA types in the tax year. So it depends on how much you want to invest within the current tax year.
Even though you can open your account with no money, you invest once you have the money available in that account. So transfer the funds you’ve earmarked for investing into your chosen investment account.
When you set up your account and transfer money in, you have NOT actually invested. You’ll need to add your chosen index fund into the account itself.
So the index fund will sit within the account. Until you select, ‘Buy’ or ‘Invest’ (depending on the platform), the money in the account will sit there as cash.
Once you’ve done that you are officially invested in an index fund!
Step 5- Automate Your Index Fund Investments
The final thing is to automate your investments.
The key to investing is to do it regularly. Even if it’s only £20 or £80 a month, it could still count in the long run.
You do this directly within the platform where you choose to set up regular investment payments into the index fund. This will be done as a direct debit from your bank account and you can select the amounts and dates of the payments.
Ensure that you set this up to be invested into your index fund and not be left as cash in your account.
Set and forget is the aim of the index fund game.
The beauty of index funds is that you don’t have to follow investing news or review your investments daily.
You can easily set up your index fund and let the monthly payments go into it, and go about living your life. I’d say perhaps look at your investments every quarter.
Remember, investing is a long term strategy!
Key Points to Invest in Index Funds
This is a bit hands on in the beginning but once done and set up, it is a passive investment strategy. You literally set it and let it tick like clockwork.
The fact that you can invest in ONE index fund and instantly have a portfolio of a number of companies at such a low price is incredible.
Great investment strategy for the beginner investor or those who don’t want to be active investors.
Have a long term horizon. You may not see much difference after a couple of years but keep going. Wait till you get to 5 or 10 years and see the impact compounding interest has.
Take Action to Invest In Index Funds
Well done! You’ve done something to take you a step closer to invest in index funds, now take the next step!
Look into your pension, research into indexes, or open that investment account.
Save this so you can easily refer back to it as you are setting up your index funds.
Share this with your friend, family, or partner and discuss investing in index funds. Make investing a regular conversation with those around you.
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