Index investing is a popular investing strategy among retail investors because of its simplicity and effectiveness in building wealth.
It is also the strategy that I use myself and would personally recommend to anyone who’s looking to start investing.
When I realised that I haven’t written a guide all about index investing, I knew that it was way overdue.
So, here is a beginner’s guide to understanding index investing – how it works, why it works, and what you should look out for.
What Is Index Investing?
Index investing is a passive investing strategy that tries to replicate the returns generated by a market index.
This is usually achieved by investing in Exchange Traded Funds (ETFs) that closely track the desired market index such that any movement in the market index is also captured by the ETF.
As a result, the ETF serves as a proxy for the desired market index such that its performance would be reflected in one’s investment portfolio.
Passive investing is when investors buy securities and hold them for the long term without trying to time the market by “buying low and selling high”.
The goal here is to accumulate wealth on the basis that markets always trend upwards (ie generates returns) in the long run.
Since the above statement is true only with respect to the general market and not individual companies, index investing is a popular passive investing strategy where a broad market index is selected.
A market index is a proportionately defined portfolio of investment securities that represents a specific segment of the market.
For example, the S&P 500 index defines a list of US companies and the proportions in which they make up the list that is representative of the top publicly traded companies in the US.
The S&P 500 index is thus a good indicator of the performance of the top US companies and is also often used as an indicator of the overall US stock market.
Exchange Traded Fund
ETFs are baskets of securities that can be traded on the stock exchange and are commonly used to track market indexes.
A market index is merely a list of securities and cannot be traded by investors.
So, in order to invest in a market index, you need to invest in an ETF that tracks the desired market index.
How Does Index Investing Work?
As explained earlier, index investing can be summarised with the following points:
- Choosing a broad market index
- Investing in an ETF that tracks the chosen index
- Holding the ETF for the long term to accumulate wealth
Index investing as a strategy is based on the premise that markets always go up in the long run, according to economic cycles.
So, by investing in an index that is broad enough to be representative of the world economy as a whole, you will always yield positive returns if you hold it for long enough.
This means that if you had invested $10,000 in the S&P 500 in 1992, it would have been worth $169,334 at the end of 2021!
And this is solely due to how the market performed on average throughout this period.
Of course, there are some things to take note of to ensure the effectiveness and reliability of index investing as a strategy, which I’ll touch on below.
What Makes Index Investing Effective?
It’s fairly simple to understand how index investing works, but what is it about index investing that makes it an effective investing strategy?
As it turns out, there’s a lot of value to be had from its simplicity.
1: Consistent Market Returns
First, index investing always yields market returns.
This means that you’ll never beat the market, but you’ll also never lose to the market.
You can think of it as always being at the peak of the bell curve.
Personally, I see this as a benefit when compared to the alternative which is not index investing, which consequently means that your returns can be above or below average.
The problem is that it’s hard to beat the market – very few people are capable of doing so consistently, including the experts at Wall Street whose jobs are to try to beat the market.
If even they can’t beat the market, what reason do I have to believe that I can?
Meanwhile, it’s quite easy to lose to the market – your investments may perform poorer than the market average or your returns may be eroded by trading costs that you incur along the way.
With the compounding effect of investments, every year that your portfolio underperforms relative to the market can be costly.
Let’s illustrate this with an example, assuming that the market average return is 7% annually.
With a starting capital of $10,000, here’s what difference underperforming against the market by 1% every year (ie an annual return of 6%) over a period of 30 years looks like.
The final amounts are $76,122 and $57,434 for annual returns of 7% and 6% respectively, which is almost a $20,000 difference.
This difference becomes even more exaggerated if the starting capital is larger, or if more capital is added throughout the years.
While it’s not guaranteed that you’ll lose to the market every year if you don’t engage in index investing, there’s also no guarantee that you wouldn’t.
I think it’s a more prudent choice to take the market average return every year.
2: Diversified Portfolio
Next, index investing provides you with a reasonably diversified portfolio.
This is because the market as a whole is made up of many companies that are different from each other.
They could be different companies within the same industry, companies from different industries, companies with different operating countries, etc.
Just by owning a single ETF, you are effectively investing in hundreds or even thousands of different companies at the same time.
This is an amazing benefit because it increases the likelihood that the companies that perform well are included in your portfolio.
As mentioned earlier, it’s difficult to correctly identify which companies will perform well and beat the market.
And the consequence of choosing the wrong companies is that your returns might be below average, which can be very costly in the long run.
By owning more companies in your portfolio via index investing, you minimise this risk by instead choosing to take the average returns of multiple companies.
3: Self-Cleansing Portfolio
One fascinating thing about index investing is that your portfolio is self-cleansing.
This means that your portfolio can rebalance its holdings and replace poor-performing securities with better-performing ones all by itself.
This is due to the nature of how an index works.
Most indexes have some criteria that a company’s stock must meet before it will be included in the index.
Let’s imagine that company ABC has been performing well in recent years and its market cap is finally large enough to be included in the S&P 500 index.
Now, if you own an S&P 500 ETF, you will own some of company ABC’s stock.
But company ABC starts performing poorly in the next few years, causing its market cap to drop below the threshold required to be included in the S&P 500 index.
Company ABC is then dropped from the S&P 500 index and replaced with a more suitable company, company XYZ.
Now, if you own an S&P 500 ETF, you will no longer own company ABC’s stock, but instead own company XYZ’s stock.
As an investor, you’ll probably never even notice that there’s been a change in the holdings of your portfolio.
But the index has already done the legwork of purging companies that are no longer fit to remain in the index and replacing them with better ones.
So you don’t have to worry about monitoring the performance of the companies in your portfolio to decide which to keep or remove.
4: Low Fees
The way to maximise returns is not limited to maximising yield, but also by minimising costs.
And index investing does that very well.
For one, the very nature of index investing as a passive investing strategy means that it incurs lesser trading fees when compared to active investing.
Since the strategy revolves around buying and holding, fees are only incurred by investors at the time of buying the index ETF.
In an active investing strategy, investors are constantly buying and selling various securities trying to take advantage of price movements, which incur multiple trading fees in the process.
At an institutional level, the institutions that manage the ETFs are also able to charge very low management fees (or expense ratios) because there isn’t much management required from them.
All they need to do is make sure that the ETF is accurately tracking the index in question with regard to the holdings and their proportions – no analysis or financial decisions are required.
It is for this reason that ETFs like VOO are able to charge an expense ratio of only 0.03%.
Meanwhile, other funds that practice active management charge significantly higher management fees due to the amount of work that is involved.
Financial analysis of many kinds, meetings among fund managers to discuss the strategies and plans for the fund, administration costs to facilitate all of the above points, and the list goes on.
It’s not hard to find actively managed funds to charge fees upwards of 1% or even 2%.
And as I illustrated earlier, even a disparity as small as 1% can compound into large sums over many years.
5: Simple & Fuss-Free
This last point isn’t so much a testament as to why index investing works, but more a reason why I’d recommend it as an investing strategy to others.
On top of all the aforementioned reasons, index investing is truly a simple and fuss-free investing strategy that anyone can take advantage of.
There’s no fancy math or analysis involved – just pick a suitable index and a corresponding ETF and you’re good to go.
Index investing also removes the need to pick and choose which company’s stock you should invest in.
The index has already done the legwork to determine which companies are good enough to be included in the index, so when you invest in an ETF that tracks the index, you’ll be investing in all of these companies.
What’s The Catch?
So, index investing seems simple enough and appears to be an effective investing strategy.
But what’s the catch? There’s always a catch.
Well, there isn’t really a catch – index investing is truly a simple strategy that just works.
There are, however, some points that should be reiterated.
1: Index Must Be A Global Index
First, it must be emphasised that index investing works best when the chosen index is representative of the global market.
The more the index differs from the global market, the less reliable index investing becomes.
Again, this comes back to the premise of index investing where markets always go up in the long run.
This is only true for the global market – not for all indexes in general.
So if an index tracks only a niche segment of the global market, or a segment that is much smaller than the global market, there is no guarantee that it will assume the same behaviour as the market as a whole.
Broadly, any all-world index is obviously a good choice, which makes world ETFs like IWDA and VWRA that track such indexes fine investments.
It is also widely accepted that the US stock market alone is representative of the global stock market, given that the US accounts for ~60% of the global stock market.
This means that an index that tracks the US market like the S&P 500 is also a plausible option, making ETFs like VOO and CSPX good investments as well.
2: Long-Term Investing Only
Next, index investing is only a reliable strategy if you’re able to stay invested for the long-term.
There’s no exact definition for how long “long-term” is exactly, but a conservative time horizon to look at is 30 years.
According to economic cycles, the market is always fluctuating.
There are times when the market will be bullish and times when the market will be bearish.
Whenever we are in the midst of 1 phase, we can be sure that the next is coming.
But the kicker here is that nobody knows how long each phase lasts, and therefore when the next phase will come.
Index investing will only yield positive returns if you can stick it out long enough such that the market is up relative to your time of entry into the market.
Historically, there have been recessions that lasted as long as 10 years, causing the market to also be in a downward trend.
If you had invested money before the recession and planned to use it in 10 years’ time, you would’ve lost money.
The longer you can afford to let your investments stay in the market, the more likely you are to yield positive returns.
It is also for this reason that the advice “only invest money you don’t need” is often shared, because it minimises the risk that you need to liquidate your investments at an inopportune time.
3: Stay The Course
Finally, for index investing to work, you must stay the course, however bumpy the ride may be.
This means staying invested even during periods when the stock market is down in the ditches and not panic-selling your investments out of fear.
The reason this is so important is that the bulk of the market’s returns are often the result of strong performance on a few days within each year.
That is to say, if you miss out on these “best days” of the market, your annual return is going to differ greatly compared to that of the market.
Historical data has shown that over a period of 20 years, missing out on the 10 best days of the market results in an annual yield of only 2%.
Meanwhile, staying invested throughout the entirety of the same 20 years nets an annual yield of 5.6%.
That difference is staggering and shows just how costly it can be if you don’t stay the course – even for only a few days.
I’ve written a whole post about missing the best days of the market, you can check it out here if you’re interested.
Index investing is a simple investing strategy that can yield great results as long as it is done properly.
The historical success of index investing is proof that you don’t need to be an expert financial analyst or trader to do well in the stock market.
Instead, consistency and commitment to staying invested are what is truly need to be successful in index investing.
What is your investing strategy?
Let me know in the comments below!
If you’re interested in investing, you might enjoy these posts as well:
- Beginner’s Guide: How To Buy Singapore Treasury Bills (T-Bills)
- A Beginner’s Guide To ETFs: What You Need To Know
- ETF Investing: A Beginner’s Guide To Expense Ratios
- ETF Investing: Accumulating VS Distributing
- Beginner’s Guide: Lump-Sum Investing & Dollar-Cost-Averaging
- Interactive Brokers: Step-by-step Guide To Buying Your First Share
- CSPX vs VWRA – S&P 500 vs World Index: Which Is Better?
- Should You Invest In CSPX And Ireland-Domiciled ETFs?
- The Best World ETF: VT vs IWDA vs SWRD vs VWRA vs V3AA vs ISAC
- The Best S&P 500 ETF For Singaporeans