Learn How To Investing In The Share Market With Index funds

It’s a common thought that investing in the share market is reserved for rich people, who spend their weekend on yachts and drive nice cars. Many people think it is out of reach, and often too daunting to us regular car driving people.

But, there is a way to invest in the share market available to most people, and it’s not as daunting as you might think. It’s not even reserved for millionaires either. This same method is recommended by investing Gods like Warren Buffett, as well as other financial experts. Who hasn’t heard of Warren Buffett?

“I believe that 99% of people should diversify and not trade. This leads them to an index fund with very low-cost.” – Warren Buffett

Now let’s break this quote down into its key elements. It talks about three things, diversification, not to trade, and index funds. First off, what is diversification?

What Is Diversification?

Diversification is the old saying that you don’t want to put all your eggs in one basket. Presumably because if you drop that one basket, all your eggs will break. Whereas, if you have them in many baskets, you only break a certain proportion of your eggs.

It’s the same with investments; you don’t want to invest all your money into one investment, say housing, in case the housing market crashes and you lose a large proportion of your investments. A rule of thumb is that you want a mixture of around 10 different investments in different investment classes.

There are many different investment classes, shares in companies, shares in index funds, real estate, bonds, peer-to-peer lending, term deposits, are all investment classes you have probably heard about. Now if you have money in a number of them you are diversified across investment classes.

But you can also be diversified within a class. This would be something along the lines of owning shares in several companies in different sectors of the market. Or if you own several different real estate pieces, some being residential and some being commercial or agricultural.

Diversification of your investments protects you from any downturns in any particular market or investment class.

So are my investments diverse?

I have investments in several investment classes. I own company shares, shares in startups, shares in managed funds, shares in index funds. I have money invested in peer-to-peer lending, money in KiwiSaver, and money in my house which does or does not count as an investment depending on who you talk to.

But is my portfolio diversified? At this stage, I would say no as I have a vast majority of my investments in my house, and in peer-to-peer lending. I need to put a larger proportion of my money into other investment classes than these two. The reason I have been doing this as I don’t like the interest earned on my mortgage. I see it as compound interest working against me. I have put so much money into peer-to-peer lending because the returns are quite good in the current low-interest environment. Although I have started to see what returns are being made in the world of index funds, I might change my tune in the next few months.

Why not be a Trader?

By not being a trader, you’re saying you will make an investment that you are willing to hold for a long time. When trading stocks or investments, there is generally some service fee associated with the trade. These fees eat into your investment.  And when you are investing small amounts like me, the fees are a large proportion of what you are investing.

If you look at ASB or ANZ securities, an online stockbroker, they charge a service fee of $30 for every trade. Now if you are trading, you have to pay this each time. When you trade $1000 worth of stock, that a 3% loss before the stock every does anything. There are cheaper options if you want to buy shares, like Sharesies, but some fees are still associated.

Ok, so why not trade real estate? Do a bit of renovation and flip the house for a profit?

Take real estate; there are real estate agent fees ( which you can minimise by selling your house privately) there are lawyer fees, bank fees associated with mortgages, advertising fees. All these fees cut into the gains that you hopefully have made over time of owning the property.

Same goes for shares or index fees. There are normally fees associated with making trades in the share market. These fees can be quite large relative to what you are investing if you haven’t got large capital invested. And if you are trading to try to earn some money on the volatility of the short-term market, you really need to consider it. Index funds also have less obvious fees. They are normally hidden in what is called an exit fee. A percentage of the value of your index fund will be paid as a fee. Normally it is smaller than share trading fees and in the order of a few per cent.

So what is an index-based fund?

If you have ever watched the news beyond the royal wedding and into the business section, you would probably have heard something along the lines of “the S&P 500 went up 20 points today” or “The NZX50 has shown little movement”.

The NZX50 and S&P 500 are both indexes. An index is a number that combines the value of many different stocks. They are used to track the overall performance of the stock market. The NZX50 contains the largest 50 publicly traded companies in NZ, and the same goes for the S&P 500 for the USA. The NZX50 contains stocks like:

  • Auckland Airport
  • Air New Zealand
  • Fletcher Building
  • Fisher and Paykel
  • Kathmandu
  • MainFreight
  • Sky City Group
  • Spark NZ
  • The Warehouse Group

They are all big companies with a proven track record. And these 50 companies make up around 90% of the stock on the market when I last checked. So this fund is basically the whole NZ stock market in some respects.

If you invest in the NZX50, you are investing in basically the whole of the NZ stock markets. Your investment will go up if the NZ market goes up, and your investment will go down if the NZ market goes down. And you would also receive your share of any dividends that any of the companies paid out.

Below is the NZX50 for the last five years, and it has averaged an annual return of 8.85% over those 5 years.

What is an ETF?

An ETF is an abbreviation of an electronically traded fund. They are similar to an index fund, but they are not the same. When you buy an ETF you buy a fund that tracks the original stock’s value, but you don’t own any of the stock and hence don’t receive the dividend. Many different ETF providers offer an ETF index like the NZX50. This is a fund that tracks the performance of the NZX50

The advantage of Index fund ETFs is that you can buy an index with minimal fees associated with purchasing. You get a share of every single company without purchasing them all individually. This diversifies your stock holdings.

As you have already learned, diversification is key because it spreads your risk. And with the low fees because most EFTs are passively managed, and relatively good returns (NXZ50 averaged about 9% over the last 5 years, I think index ETF are a great investment tool.

Unless you think you are better than the market, some sort of wolf of wall street hotshot, you should probably stick to passively managed index funds. Many different studies have shown time after time that passively managed funds outperform actively managed funds.

When should you Buy?

We’ve all heard it. Buy low and sell high.

That is the right idea, but who has the time to track stocks and figure out when they are low and then pick the top and quickly sell?

It turns out; many investors do the exact opposite. I know I hear you screaming “HOW”? Well, it turns out we humans are emotionally driven.  Losses hurt more to use than gains. And when we see a stock doing well, we tend to want to buy it. But when you buy into an upswing of stock, you are likely buying closer to the stock’s peak. Once the stock drops slightly, many investors can get scared and sell prematurely because we see losses and don’t want to continue losing more.

Just like the Brexit panic, the NXZ50 plummeted before it happened on the 26th of June. Many people would be selling thinking they were cutting their losses short. But if they had just waited until August, they would be positive again. If you’d sold your shares out of fear then, you’d be feeling like an idiot now.

Invest, don’t speculate

When you are Investing, your aim should be to gain from companies’ long-term returns, speculating is trying to profit from short-term market movements. Basically becoming a trader. There is no real point in trying to outsmart the stock market. And the majority of the time you won’t be able to.

These days you are up against algorithms and companies with billions invested. The chances that you, a personal traded, can outsmart these companies with hundreds of employees and massive resources at their disposal can outsmart them is very slim. I would say next to none.

Index investing doesn’t take time

Investing in index funds is not at all time-consuming. I invested in several last months, and it took me less than an hour to get an account sorted and invest in the index funds I wanted to invest in. Mind you; I already knew which ones I wanted to put my money into.

Not that I have these funds open, everything is automated. I get paid, money is transferred into my fund account, and index funds are automatically purchased.  You can check out the funds that I bought in my latest passive income report.

Dollar-cost averaging

Because I aim to purchase these funds continuously, I am using what some would call dollar-cost averaging. The market has gone up or down, day-to-day. I call this noise; I am only interested in the larger time frame. So when I purchase index funds every two-week, the market could be up, in which case I get fewer shares for what I have invested. Or the market could be down, in which case I get more shared in the fund.

This means I don’t need to time when I purchase shared, as it all averages out. This stops you from making a mistake trying to time the market.

You don’t need to be a millionaire get started

Recently, there has been a flurry of new companies offering ETFs and passive index funds with low fees. These include smartshares, Sharise, and InvestNow.  These companies offer different fee structures, such as a yearly fee of $30 with no brokerage fees. Some have fund service fees. But they all are historically cheap when compared to fees charged by banks and brokerages.

So what do you think?

Do you agree that investing in the stock market through low-cost ETF’s is a way to go? I would love to hear your thoughts in the comments below.

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