Step 3: Index funds

Tweet

This is step 3 of my private economy, saving and investing series. Be sure to read the other posts as well:

Step 1: Stabilize your economy
Step 2: Expectations and mindset
Step 3: Index funds

An index fund. The simplest way to invest in a diversified way.
Lets start at the basics and look at Funds in general.

What is a Fund

An investment fund is a way to put together a sum of money from a number of investors and then investing that sum into some kind of financial resource, it could be common stock, bonds or more advanced instruments or a combination of all.
Funds usually specialize in certain specific areas. For example geographical funds could be focusing on for example:

• Japan
• Asia
• Eastern Europe
• Asia excluding Japan
• and so on

Other funds specialize in different sectors. For example

• Industrial
• New technology

The standard funds are usually managed by a business that takes out a fee for the trouble. The trouble being to decide what resources to invest in, when to invest and when to sell those holdings.

Many funds are rated based on their performance, many are measured against how well they manage to beat the market. Meaning, how good was the manager in picking stocks and timing the market during the previous week/month/year.

But there is a catch, nothing about their past performance can predict a funds future performance. Meaning that even if a fund did all the correct moves during last year, there is no way to predict if it will continue to do so.

In recent years, there have been many scandals where these money managers basically hug the market index that they are measured against and still collect huge fees.

So what to do? Managed funds have huge potential but at the same time there is a downside.

The good:

• Diversified investment
• Professionally managed

The bad

• High fees that eat into your profits
• By nature, fund managers want to beat the market and to do so they need to buy and sell the resources that they invest in. There is a risk that the fund will be worse than the average index.
• There have been incidents where fund managers mimic the fund that their performance is compared to. And still take out high fees. Just make sure you understand the philosophy of the fund.

The index fund

So, why trust in a person/business to select what to invest in when you can buy into a fund that is automatically managed to mimic one of the market indices. As the fund is automatically managed, these funds usually have much lower fees.

The good:

• Diversified investment
• Automatically managed / Passively managed
• Lower fees
• Not much trading in the underlying resources. Only when a company is moved out of the index and new ones are introduced.

The bad

• Booooooring. You just add money to the pile for a long period of time. Not a 
• Easily automated, as it is just adding more money each month.
• Other investors can foresee when a large index fund is going to sell or buy and thus do an index arbitrage. This affects the whole underlying index and thus, when comparing the funds performance to the index it is not seen. But it is something that exists, but should imho not really affect your investment.

My conclusion

When I started out investing I was a bit unsure what strategy to take so I followed the following:

if you invested in a very low cost index fund – where you don’t put the money in at one time, but average in over 10 years –you’ll do better than 90% of people who start investing at the same time
-Warren Buffet

Ok, I haven't invested for 10 years so I have no way to prove the above statement, but when looking at historic data of indices it seems like this is the way to go.

Disclaimer. I am in no way an expert on capital management or investing. On this blog I only wish to share my findings, ideas and comments on current events and fields that interest me. I hope that my thoughts can entertain you. I expect that everyone reading take their time and do their own research before acting on anything read on this blog. Investing is not for everyone. E&OE.