In our last post, we tackled some of the most common myths in the world of investing. Today, I’m delivering a lesson on the fundamentals of one of the best wealth building tools the world has ever seen.
That’s right kids. We’re going back to school.
A journey back in time…
Like all good lessons, this one begins with a foray into history. The year is 1923, and in the USA, Mr Calvin Coolidge has just taken over as President.
In the depths of Lower Manhattan, New York, a group of business executives sit around a boardroom table, eyeballing each other through thick plumes of cigar smoke.
The topic of discussion? The US stock market.
This group of executives made their living by rating the riskiness of various publicly traded investments. Primarily, they analysed something called mortgage bonds (explainer coming soon). Now, they were looking to branch out into stocks too.
After hours of discussion, the men stood up, shook hands, and poured themselves a well-deserved glass of bourbon. The Composite Index had just been born.
Cool story. What’s it got to do with investing?
Today, we know the Composite Index as the S&P 500 Index. You may recognise this name from perusing the daily broadsheets or flicking through the news channels.
“The S&P 500 gained on Monday as traders shook off recession fears and bought technology shares that were beaten up in the first quarter“.
Such terminology is common in the world of investing. But what is an index?
Put simply, an index is a measuring device that tracks the performance of a select group of companies.
Think of it like following your favourite football team. The team is made up of individual players, and the players’ performances dictate the results of the team.
When the players perform well, the team does well. When the players perform badly, the team does badly. In this way, the team’s results (whether they win, lose, or draw) represent how well the players are performing as a collective group.
An index works in exactly the same way, except instead of players you have companies, and instead of a team you have the index.
When the companies perform well, the index performs well. When the companies perform badly, the index performs badly. All the index does is represent the collective performance of the companies. And the S&P 500 Index tracks 500 of the largest companies within the US.
Okay, but how can this make me money?
Let me introduce you to a man named Jack Bogle. He has attained legendary status in the world of investing, and for good reason.
In 1976, Jack had a world-changing idea. Because indices (which is the plural of index, don’t you know) represent the performance of a basket of companies, the performance of the index can be tracked year on year.
For example, if the average share price of all the companies within the index increases by 2%, the index itself will increase by 2% too.1The maths here isn’t an exact average for some indices. For instance, the S&P 500 is actually weighted in favour of larger companies. This means that the performance of companies in the index with a larger market share will have a greater overall effect on the performance of the index than companies with a smaller market share. As I’m writing this, Apple is the largest company in the S&P 500 and accounts for 7% of the index’s performance. On the other hand, Ebay, which is much smaller in comparison, accounts for less than 0.1% The index simply tracks the collective performance of the individual companies which it contains.
So where does Jack Bogle come into all of this?
Well, he realised that you could create an investment product which tracks the index. Kind of like an index of the index.
This investment could then be bought by normal everyday investors, like you and me. If the index goes up, your investment goes up. If the index falls, your investment falls. The two are inextricably linked.
Right. So I can buy an investment that tracks the index. Is that a good idea?
The investments that track the index are known as ‘index funds’ or ‘tracker funds’ (stunningly creative, I know).
Instead of relying on the results of one individual company, like Starbucks, Tesla, or Twitter, an index fund can rely on the collective performance of hundreds or even thousands of companies.
This means that index funds are more diversified (i.e. ‘safer’) than the stock of a single company.
For example, an index fund which tracks the S&P 500 Index is linked to the performance of 500 of the largest and cleverest companies in the US stock market.
This means that even if Twitter shares are having a bad day, other companies within the index (like Starbucks or Tesla) could do well and offset the losses.
Overall, the value of the index increases and you get a positive return on your investment, despite the poor results of one company.
Right. So investing in an index fund is a bit like investing in hundreds of different companies?
Bingo. Full marks. And it really is that simple. A financial expert (called the ‘fund manager’ – another stroke of creative brilliance) will be in charge of managing the index fund on your behalf.
The beauty of this is, once you’ve invested in it, you don’t have to lift a finger.
The fund manager will ensure that the index fund correctly tracks the index, and you don’t have to worry about buying or selling any shares. You simply hold the fund and watch it grow. You can learn more about how this works here.
I think I understand the basics about index funds now. Is there anything else I should know?
So far, we have used the S&P 500 Index as an example of how an index works.
But the S&P 500 index isn’t the only index in existence. In fact, there are hundreds of others. The following are a few of the biggest examples:
- FTSE 100 Index – Tracks the performance of the 100 largest companies on the London Stock Exchange.
- NASDAQ Composite Index – A weighted index of over 3,000 companies listed on the NASDAQ stock exchange.
- Dow Jones Industrial Average – A weighted index of 30 of the biggest companies in the US.
- NIKKEI 225 – An index of 225 of the largest companies in Japan.
As you can see, an index can track any number of companies from around the world. And for pretty much every index, there is a corresponding index fund that you can invest in.
I like the sound of an index fund. What next?
It’s important to note than an index fund is just one type of financial investment which can give you exposure to the stock market.
When compared to trading the shares of individual companies, an index fund is much lower maintenance (thanks to your trusty fund manager) and is generally more diversified.
But how does an index fund actually perform in the real world? Will it make you thousands, millions, or simply leave your wallet empty with nothing but an expired library card to show for your troubles?
In my next post, I’m going to use real world examples to show you how index funds perform in reality. I’m also going to explore the best investment strategy that people use to extract maximum value. Be warned, the results may shock you.
Lesson over. See you in the next one.
Note: I’m leaving some further resources below which link to additional reading on index funds. If this is the first time you’ve hear about an index, or an index fund, it can be a bit overwhelming. I hope I’ve explained it in an understandable way, but if not, leave me a comment and feel free to ask any questions. Thanks!