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.

Step 2: Expectations and mindset when investing

Tweet

This is step 2 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

Now we have done some ground work.

An automated savings plan is in place and a buffer is filled for the rainy day. So whats next?
By now you might have noticed that the ordinary savings account has a pretty low interest rate, if at all. It has become more and more common for 0% interest rates on savings accounts.

For us it was a deal with the bank to start an investment account to get a better interest rate on our house loan.
We did not know much about how the capital market worked when we signed the deal, only what we picked up in the news and movies. The popular cultural view includes

• A lot of trading. Movies love day-traders and Wall Street corruption. Buy! Sell! Follow the markets up and downs.
• Speculation and the quest of finding the next big winner. In my ears this sounds like a lot of work and a high risk.
• Small daily variations in trade make big head-lines in financial news. But then again, real journalism seems to be hard to find these days.
• The market always has the correct pricing due to the volume of trade.
• Stocks are just numbers that can be statistically analysed.
• Stock picking is everything there is to it.

The first book on the subject that I read was The Intelligent Investor by Benjamin Graham and the biggest eye-opener for me was the notion that when you buy into stock of a certain company, you actually own a certain part of that company. If your company does well, it will pay you back, if it goes bad it will not.
The strangest thing is that I never thought of that before. The abstraction of a share has taken over.

Definition of the word Invest.

"To commit (money) in order to earn a financial return"
-merriam-webster.com

"Put (money) into financial schemes, shares, property, or a commercial venture with the expectation of achieving a profit."
-oxforddictionaries.com

"To put money, effort, time, etc. into something to make a profit or get an advantage"
-dictionary.cambridge.org

The investing options discussed on this blog follow these definitions. The common idea is to put money or time into something and expect a return on that investment in the form of money.
Many people think of their house or apartment as an investment but in my mind the money you put into your house is in a very grey area, even if you make a profit when you sell it you will still need somewhere to live.. Buying an house and renovating it and then reselling for a profit is a investment. Your home should not be. If you earn some extra cash on moving, see it as a bonus and put it into your investment plan.

Don't expect to get rich fast, it will take time but in the long run if you stick to the plan you will start to get returns that in the end will blow your mind.

Mr Market

Grahams famous allegory of Mr Market goes something like this: once you become a shareholder you will start to get daily visits by Mr. Market with a price quote on your shares. But some times the quote is ridiculous and it is up to you to either trade with him or not. It does not matter if you do or not, because if you are still a shareholder the next day, he will come back. Mr Market listens closely to every piece of information and follows every lead when setting the price tag on a share.

Lets fast forward to present time, today Mr Market comes to visit more frequently. He pretty much comes multiple times per hour if we let him. But it is still you, the shareholder, who must either accept his offer to trade (either buy or sell) or not to.

Day-traders continuously negotiate with Mr Market and trade with him multiple times per day to gain a profit. They do not look at their shares as parts of a real physical business but more like paper with a price-tag on them. In my mind, this is a very high risk game and the only real winner is Mr Broker.

Introducing Mr Broker

Where Mr Market is the provider, I like to see Mr Broker as the pusher. He wants you to do business with Mr Market.

Mr Broker is the guy you call each time you want to trade with Mr Market. He does all the paperwork and takes a small fee for the favor. In the end, if you trade a lot, he is the only real winner. Think of it as the house always wins at the casino. So the key is to involve him as little as possible. Mr Broker loves the news and the manic-depressive Mr Market as they increase the amount of trades per day. Mr Broker is a very very rich guy.

One of the things with Mr Market that Graham left out of his allegory is that he is a pretty bad guy, not only does he have manic-depressive traits, he is also a stalker. Even if you sell every share that you own to him on one day, he will come back the next. And continue to do so. Meaning that you will have a pretty good picture of if the decision you made was a good one or a bad one.

Grahams strategy to battle Mr Market is to diversify your holding. Meaning that you buy into businesses in different fields, that are undervalued by Mr Market and when they rise a little you sell them back to him for a profit. And you continue to do so until you get rich one step at a time.
In my mind this requires a lot of work even though the risks are quire small.
Or you could just buy into an index-fund that is built to automatically mimic a certain markets index. This is what I did when I started out. More on that in a later post.

In conclusion.

If you get into investing with the mindset that shares are owner certificates for a businesses you will probably have a better outset than most. View yourself as an owner and read up on their business instead listening of the wild speculations done by news, media and the market in general. Take your time to read a report or two, perhaps even go to an annual meeting, and only engage in a trade with Mr Market on your own terms and limit the number of trades so that Mr Broker doesn't steal your profit.
If you do not want to do that, then stick with Grahams diversification plan and buy into an index fund with a low fee whenever you have a nice sum of money to put away.

Continue to the next step: Index funds

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.

Step 1: Stabilize your economy. Buffer and Savings

Tweet

This is the first step 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

As a first step before we even start thinking about investing is to lay out the foundations for a stable living. A buffer and a savings account.

Savings account

My old approach to saving was pretty much ad-hoc:

1. Get paycheck
2. Pay bills
3. Go on with life
4. Receive next paycheck and move whatever was left to the savings account.

Many times it was nothing, and some months I took instead of put money into the account.

Needless to say, it felt very hard to save for something specific.

The big issue with the ad-hoc approach is that there are a lot of variables in life and even if you cut away something, it is a long way for it to actually get to the savings.

The first change to do is to change the order of things. Namely, to put away money as the first thing instead of the last. This will result in a more deterministic savings.

Deterministic savings mean a lot of things.

• You will put away the same sum each month. 
• This allows you to plan your future financial situation. 
• You can automate it, meaning that it is more likely that you keep your plan if you never actually see the money on the spending account.

It also means that if you plan to save a certain amount each month, you need to stick to the plan. After the money hits the savings account, you should look at it as if it is out of reach and not usable. We usually refer to it as monopoly cash or toy cash. It looks and feels like real money, but you are not able to use it.

If you want to increase your savings per month, try removing from the other sections by for example canceling a subscription. Do you really read that magazine? Directly when you cancel, also change your automatic savings amount. This way you actually save the money and not just use it on something else.

The buffer

From time to time, life happens and your paycheck is not enough and you need to solve the situation by going to the savings. But in the section above we agreed that the savings account was off limits, how do we solve this?

By creating an extra account, preferably an actual account in the bank. How big this has to be is up to you, but the key is to always have it at the level that you have decided.

If you need to take money from it one month, you pay it back the next before all other savings or bills.

If you need to use the buffer continuously, then you need to change some habits. Maybe cancel a subscription, skip a restaurant visit or something similar.

Conclusion

In the end, it is not that much work but quite a lot of determination to keep to the plan. The key idea being to pay yourself first before doing anything else. Start small, and grow it over time.

Continue with step 2: Expectations and mindset

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.