Index Funds: The Only Investment Guide You Need to Read

Hey!
My earlier posts urged you to start investing as soon as possible. But now you are wondering what you should do next.

You are thinking: “How do I get started on investing?” Fret not! Read this and get started on the road to your financial freedom.

Here, I present an easy strategy that will guide you on how/where to invest. If you follow this, you are statistically guaranteed to beat 95% of the so-called “financial gurus” in the long term. So what is the magic strategy? It is known as index fund investing.

So, let’s start learning about it.

Introduction: Stocks and bonds

In one of my earlier post, I explained in a simple way what stocks and bonds are. We learned that they are investment vehicles that can be used to reach our financial freedom. But many of us get petrified when thinking about stocks (and bonds) as investments.

Many have this notion that purchasing stocks is akin to gambling/speculating.

While some others consider the stock-investing process as daunting and overwhelming.

But nothing could be further from the truth. Over the long term, stocks and bonds are rock-solid investments. It could be argued that they are one of the best long-term investment vehicles to grow your wealth, especially for the “average” folks like you and me.

Furthermore, stock investing is not complicated. If done right, they are easy-peasy.

The best stock investment strategies are often the simplest.

I would even go one step further and even state that, if your stock investing strategy is complicated or overtly time consuming, then you are most probably doing it wrong.

So, what is this simple stock investing strategy?

The best stock investing strategy

They are known as index fund investing. So, what do they mean exactly?

Allow me to skip the intricate details and present the relevant information in a highly-simplified manner. I am going to illustrate index funds with the help of an example.

Assume that in a small imaginary country called Amurica, in total there exists only 6 companies, they being:

• Microsoft
• Apple
• Nestle
• Amazon
• Coca-Cola
• BMW

We learned earlier that since these companies need money to function, they sell a part-share of their companies as stocks. We can go to the “stock-market” and buy these stocks by paying some money.

Then companies are obligated to share their future profits with us according to the amount of share we buy. This is essentially the whole concept of stock investing.

Now, comes the big problem. What investing strategy do you employ? In simple words, if you have $60 with you, how do you decide in the stock-market which shares of the company to buy.

Obviously, there are multitudes of solutions for this simple problem. One such solution is known as index fund investing. Later, we shall also see how this simple index strategy compares with other strategies.

Index funds

In index investing, you do not buy shares of individual companies. Rather you buy an index. What in an index you ask?

Index is a basket of stocks grouped according to a certain criteria. For instance, in our previous example we could group all the stocks in the country Amurica and call it the $AMURICA index.

Or we could group all the technology stocks in Amurica and call it the “$AMURICA_TECHNOLOGY” index.

Or we could group all the food stocks in Amurica and call it the $AMURICA_FOOD index.

I hope you understand what indexes are now. It is simply a hypothetical group of stocks picked according to a certain criteria.

Index fund investing

So, now let us return to our original discussion of buying an index fund. When you buy an index fund, you buy all the constituents of that index fund.

For example, assume you buy $60 of *$AMURICA* index fund. What is essentially happening in the background is that the money would be split and invested, i.e. $10 worth of shares in every company will be bought. Here, I assume that all companies have equal market value (i.e., equal net worth), and that the index fund splits money according to market capitalization. There are many ways to split your money and put it into the respective constituents. More about this coming soon.

Similar thing would happen if you buy *$AMURICA_TECHNOLOGY*index fund. Your money will be split into 3 parts and you will buy$20 worth of the the three companies.

This is all there to it in Index fund investing.

It is simple, uncomplicated and very boring. Also, remember the constituents of an index rarely change. They are static. That is every time you invest in an index fund, you just keep investing in a group of stocks. You do not care, which company is performing good or bad, you do not keep track of market movements, you just keep investing into index funds. The index fund splits the money and buys different companies.

Some famous index that you might often see in the news channels:

• S&P 500 – 500 largest companies in USA.
• DAX 30 – 30 largest companies in Germany.
• NIFTY 50 – 50 diversified companies in India.

Hurray! Now, the next time you see financial segments on news channels with such indices (with green and red percentage ticks attached to them), you will understand what they are. When I was young and watching news channels, the financial segments always remained a mystery to me. In fact, they mostly just inform the performance of different national indices.

Why this is the best?

Many of you might be thinking how the hell is this best strategy?

If I have $60 dollars in hand, would I not be better off investing in companies that I know are going to super-profitable. For example, 10 years ago would it not be better to invest the whole$60 in the company Apple, rather than investing in an average index fund? In hindsight, Apple was super-profitable compared to the average return given by an index fund.

Allow me to answer this question in a circumspect way.

There are people in suits and coats whose entire profession revolves around answering this question. These people run their own funds. In these funds, they promise to always hand-pick the best stocks. They throw away bad-ones and always try to buy the good ones. They keep changing the constituents in their stock basket. Day-in and day-out they identify which stocks are going to be profitable.

They urge normal folks like you and me to invest money in their hand-picked funds. They promise us bountiful profits in return. Typically, these people are said to be running mutual funds. Also remember, they are no ordinary folks. They have the best financial degrees from the best colleges. They use the latest technologies and analysis.

Definitely, with all this sophistication, these people ought to outperform index funds over the long term. Let’s compare the statistics of such mutual funds with index funds.

This table shows how many stock mutual funds out-performed the S&P 500 index fund in a 20 year period. You can clearly see most mutual funds under-performed. Even more amazing, is the fact that this statistic does not include the mutual funds that went bust, broke and disappeared over the long-term. Including that fact, would further tilt the number to index funds.

The conclusion is over long-term, most mutual-funds will under-perform the index funds.

So, there is a clear answer here: No, you cannot cherry-pick stocks. If mutual fund managers with all their sophistication cannot hand-pick stocks, what hope do average investors like you and me have?

You are better off investing in broadly diversified index funds. By broadly diversified, I mean something like S&P 500. It tracks 500 of the largest companies in the USA across diversified sectors such as technology, banking, food, industrials, and so on. In simple words (like our earlier example), investing in S&P 500 is almost similar to investing in an $AMERICAN index fund.

Obviously, there are plenty of other options for index funds. If interested, have a look at the index funds that I invest in here.

Closing words about Index funds

• I agree that I have not properly described why mutual funds (with their superior brain-powered backing) so severely under-perform the bland boring average index funds.
• Secondly, I have not given reasons why you should invest in broadly diversified index funds, rather than small sector-focused index funds.
• Also, within broadly-diversified index funds, there are many options. I have not specified which index funds to buy among them. If you asked me to name one now, then it is S&P 500, you cannot go wrong with this one!

This is to keep this post short. I promise to describe this all in upcoming posts. So, please keep watching this blog. Or even better SUBSCRIBE here and I will notify you via email.

And for the ones that still have the doubts about the index funds. Let me close this section with the quote of Warren Buffett, one of the richest and the most successful investor in the world. This is what he is planning to do with his own personal fortune, after he has left us :

“My advice to the trustee could not be more simple. Put 10% of the cash in short**‐term government bonds and 90% in a very low‐**cost S&P 500 index fund. I believe the trust’s long-term results from this policy will be superior to those attained by most investors—whether pension funds, institutions, individuals—who employ high fee managers.” – Buffet

His recent 2017 advice to the investors like you and me (btw, this has been his advice all years along, it has always been the same-mantra)

“Both large and small investors should stick with low-cost index funds.” – Buffett

Do you want to go against the advice of the most successful investor in the world?

Not me!

Conclusion

• Stocks (and bonds) are great vehicles to reach your financial freedom.
• Stock investing is neither gambling, nor very daunting
• The simplest and best way to invest in stocks is to follow: Index investing strategy.
• The other tempting option mutual funds, over long-term severely under-performs index investing strategy.
• So, as outlined in an earlier post, the roadmap for your financial independence is this:
  • Save as much as you can every month.
  • Regularly invest this saved money.
  • Do not cherry-pick stocks.
  • Invest always in low-cost broadly diversified index funds.

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With my first three posts, I have already introduced you to the three check posts of your financial journey. But there are several such check-posts that have to be crossed successfully to complete the journey.

In this blog, I hope to write more about these check-posts and how to get there as easily as possible. So please SUBSCRIBE if you would like to be notified when such posts come out.

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Until the next time, Ciao!

If you liked this, you might also like:

1. Why should you start investing?
2. When can you attain financial independence?
3. Theory of investing Part 1: Stocks and Bonds
4. Index funds: The only investment guide that you need to read
5. What kind of investor are you: Defensive or Enterprising?