Index funds and mutual funds have surged in popularity over the past decade, and for good reason. These types of investments can provide many benefits for investors.
One of the most important benefits, and the reason why I recommend these types of funds, is their simplicity. Simple to use, and simple to understand.
Of course, when it comes to personal finance, the entire finance industry is built on taking something simple, and twisting it into something impossible to understand.
The same treatment has been performed on our beloved ETF’s and mutual funds, all wrapped up beneath the mathematical concept of indexing.
What is an Index?
In its simplest form, an index is a way to measure something.
It’s actually a concept we’re all very familiar with.
The average test score from your class in a certain subject is an index. The win % of your favorite team is an index. The gas mileage (mpg) on your car is an index.
You are measuring something, taking a list of data, and using a mathematical formula to draw inferences from that data. How well you performed compared to class average, for example. But, you could look at a different index, and come up with a different result. How you compared to the class median, for example. Comparing your scores to the mean versus the median, may give you a very different outcome.
And that’s just cutting the surface of indexes. A different index could look at test scores by birth month, weighting heavier those born in the summer months, and lighter those born in the spring.
This of course, is just scratching the surface, because we’re still only looking at our class test scores. The machinations of finance can take those scores and chart them against neighboring schools, states and even nations.
Indexes in Finance
As a way to measure something, that definition is incredibly vague. That leads to all sorts of different numbers, able to be used in different ways.
Take the S&P 500 for example. This index of 500 of the largest publicly traded companies looks at an average based on market capitalization. It’s actually fairly logical, that a company like Apple or Amazon, with enormous market capitalization (Share Price times Shares Outstanding) should be more heavily reflected than a much smaller company like Molson Coors.
Compare this to another well known index, the Dow Jones Industrial Average (DJIA). DJIA is indexed based on a modified market price weighting. This places the weighting based on share price, and not on market capitalization as we saw with the S&P 500.
For example, picture Company A with a market cap of $100,000, made up of 10 shares worth $10,000 each. Compare that to Company B with a market cap of $1,000,000, or 10 times the size. But Company B has a share price of $5,000, and 200 shares outstanding. Using a price weighted index would more heavily weight the much smaller Company A, based solely on its exclusive and very expensive share price.
An Index for Everyone
The increasing popularity of index funds for retail investors has led to an equal surge in institutions creating these funds. Just like a walk down the cereal aisle, you’ll find a fund for anything.
Regular flavors aren’t enough? Try frosted flakes. Or fruity puffs. Or chocolate crunch. Or anything in between.
There are index funds for the environmentalists. For manufacturing, farming, heck, even vegan ETFs can be bought. Whatever flavour you’re looking for, you’ll be sure to find it. And if not? Someone will make it for you, for a price.
With under 4,000 publicly traded companies in the US (3,671 in 2020), there are almost 8,000 mutual funds that package and split those stocks in every imaginable combination.
If that sounds like a lot of funds, you’re right! Now imagine the cost of maintaining so many complex, confusing indexes (groupings of stocks). The added complexity is staggering, and the costs are ultimately borne by you, the buyer.
Which one(s) to Buy?
I cannot tell you which fund will outperform the market this year. Nobody knows that. And anyone who claims they do, is trying to pull a fast one on you. But, there are a few criteria that you should follow when buying your investments.
Know the assets - if you can’t tell what the calculation is, and understand what you’re holding, you probably shouldn’t be investing in that fund. As with most things, investing is simple. It’s not easy, but it’s simple.
Ignore past performance - this might sound counter-intuitive, afterall, you want to back the winning horse. But there’s a very good reason every marketing pamphlet carries the same disclaimer, “Past performance doesn’t guarantee future results.” That line is completely true. What was best last year isn’t guaranteed to be best again.
Control your costs - if you take only one thing away, it’s this: minimize your expense ratio. Expense ratio refers to the costs charged to create and maintain the fund. The more complex the fund (or the greedier the fund manager), the higher the expenses. Those expenses mean you not only need to pick a winner, you need to beat the average by whatever rates they charge. Consistently picking the fastest horse is almost impossible. Picking the horse, who then starts half lap behind the competition is insanity. Don’t stack the deck against yourself.
Index funds, when done right, can pave the path to financial freedom for you. But there will always be those trying to take advantage of such opportunities.
If you want to find investing success, stay vigilant. Don’t put your money into something you don’t understand. And avoid handicapping yourself as much as possible. Investing doesn’t need to be complicated. Buy into a cheap fund, with good total market coverage, that you understand. And keep buying, month after month, no matter what the price is doing. Do this, and one day you’ll wake up rich.