This article is a high level overview of index investing- a deep dive article might get done if there is appetite for it!
There are many different ways to invest in stocks and shares- from being a single share in a company like BP- to buying (part of) a fund. What’s best for one person may not be best for another.
If you are investing for the long term (think 5+ years), and you really should be, then buying individual shares in a single company is pretty risky. Companies can and do go bust/into administration- if this happens and you only have this one investment….. you can possibly end with nothing! So, what can you do? Spread the risk and invest into multiple companies? Sounds like a good idea, until you realise that your broker charges you for each deal you want to complete- usually between £5-10. So, if you want to buy into 10 companies, instead of 1, your costs of doing so just went up 10x as well. So, instead of your investing costing £5- its costing £50. Now, if you do this on a yearly basis- this isn’t such a bad idea, especially if you are talking tens/hundreds of thousands, but what if you are talking about hundreds or thousands? Enter….. index funds!
What are index funds?
They are like a basket of stocks & shares- that aim to replicate an index- such as the FSTE 100. So instead of you having to not only just buy 100 different shares (in this example)- it also balances this for you. So, if you were to replicate this manually, not only would you have to buy 100 different shares- you would have to buy the correct amount of each based on their weighting in the index. Shares change value continually- so as their value changes- you would need to sell/buy in order to maintain your exposure to this index.
What are the advantages?
Index funds are cheap, very cheap. Is the above calculation showed- if you wanted to buy a piece of every company in the FSTE100- you would need to place 100 buy orders, even if you managed to do this very cheaply- it would run into hundreds of pounds. You can replicate this by buying, say, Vanguard FTSE 100 Index Unit Trust– this would just be 1 buy order from your broker. Suddenly this is approx 100x cheaper!
They automatically re-balancing, meaning that the work by you is basically zero. You buy them when you want more of them, you sell them when you want less. That’s it- compared to reducing your holding if you were holding individual stocks
Risk is diversified- rather than investing in a single company- you have invested in 100 (or more)
What are the disadvantages?
When you buy into an index fund- you are buying every single company that makes up this index. If you felt strongly that a certain company was going to do badly, there is no way to exclude this-you have bought it anyway.
Your gains will be limited to the movement of the index- so all the outliers- both positive and negative will be “averaged away”. For example, if Apple grow 40%- this wouldn’t be reflective of the S&P 500 index, as Apple only makes up approx 3-4% of this index (currently).
I’m sold- what do I do next?
Pick what index you would like to invest into- and decide how much you are going to put in. Use a broker (a good comparison has been done by Monevator). And that is it- wait until you are ready to withdraw the monies in years to come.