What is index investing?

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. You can avoid all this by index investing.

What are the advantages of index investing?

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). Some of the global index funds now have over 1,000 companies now- so you end up with massive diversification.

You can even do this within an ISA– so that any gains of the index are protected from tax, no matter how well it does!

What are the disadvantages of index investing?

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.