It’s easy to think that investing in the share market is just something for rich old dudes who ride around on yachts and smoke cigars. It seems out of reach and daunting for us regular yachtless plebs.
However, there is one particular way to invest in the sharemarket that’s within the grasp of most people. You don’t need to be a millionaire or a financial wizard. This method is recommended for regular people by Warren Buffet and many other financial experts.
“I believe that 99% of people should diversify and not trade. This leads them to an index fund with very low cost” Warren Buffet.
Even if you don’t know anything about stocks you’ve might have heard of Warren Buffet. For those that haven’t, he’s basically the LeBron James of investing. Let’s break down this quote. “Diversifying” is owning a range of different investments, so all your eggs aren’t in one basket. “Trading” refers to buying and selling shares. By not trading Warren B means buying and holding for the long term.
I’ve mentioned index-based funds in previous articles. In this article, I’m going to go deeper on what index-based funds are and how they can be a great way for normal people to invest. I’ll try to make it as easy to understand as possible!
What is an index-based fund?
If you’ve ever seen the financial news you’ve probably heard something like; “The S&P 500 went up 20 points today” or “The NZX50 was flat” before you hurriedly flicked the channel to The Simpsons.
The S&P 500 and the NZX50 are both “indexes”. An “index” is a number that represents the combined value of many different stocks. Indexes are an easy way to show how a particular industry or economy is performing. This is why newsreaders refer to them often.
The NZX50 is an index which measures the value of the 50 biggest companies on the New Zealand stock exchange (NZX). It contains companies like Air New Zealand, Trade Me, and Spark. These 50 companies make up over 90% of the value in the New Zealand stock market. In previous articles, I’ve talked about how a “mutual fund” is a collection of stocks. An “index fund” is a mutual fund which tracks the performance of an index. I.e if you invested in a fund which tracked the NZX50, the value of your investment would go up when the 50 companies performed well and go down in value when they performed badly. With me so far? 🙂
Funds have “units” which are bought and sold. Let’s say an NZX50 index has units which cost $10, and you buy ten units for $100. If the NZX50 went up in value by 10% over a year, your $100 would now be worth $110! (less fees). You would also receive dividends (the amount of company profit that is paid out to shareholders) that are based on the dividends that the companies that make up the index have paid out.
Quick note: traditional index funds are seldom offered in New Zealand, but similar products called ETFs (exchange traded funds) are readily available. These are similar to index funds, but they can be bought and sold throughout the day like any regular stock. Regular index funds are sold directly from fund companies. There are some other small differences, but for this article, I’m going to call them “index-tracking ETF’s” which refers to ETFs that track an index. Confused yet?
Ok, now we know what an index-tracking ETF is, let’s get into why they are a good investment decision.
Index-tracking ETFs allow you to diversify
Owning index-tracking ETFs allows you to invest in many different companies, without having to purchase shares of every company. If you invest in an NZX50 ETF (like this one available on Smartshares.co.nz), you own a small % of each of New Zealand’s 50 biggest companies. As we’ve already learned, diversification is great because it spreads your risk. You are less likely to lose all your money than if you only bought stocks in a handful of companies. Makes sense right?
Functioning economies like New Zealand or the United States see their companies earn positive returns (and consequently see the value of their stock markets go up) over the long term. This means that, if you buy an index fund which tracks the return of an economy, you receive a portion of that economies returns. Over the last 13 years, the NZX50 has grown at roughly 9% a year.
When investing, you get what you DON’T pay for! I.e the less you pay in fees, the more you get to take home in returns!
Index-tracking ETFs are passively managed which means they just try to match the returns of an index. A computer buys and sells stocks as required. E.g if a new company entered the NZX50 shares of that company would be automatically purchased. This is different to an “actively managed fund” where investment managers buy and sell stocks aiming to get a better return.
You’d think it’d be better to have a team of hotshot investors making moves for you. In practice, this is often not the case. Actively managed funds are usually more expensive, as they pay fees every time they buy and sell shares, and they also have to pay their investment managers. ETFs, which track an index, generally charge comparatively lower fees as they don’t require expensive managers. E.g. this ETF tracks the largest 500 companies in the United States, and its annual fee is only 0.07%. That’s only $7 for every $10,000 you invest!
Most investors buy and sell at the wrong time
In the Simpsons, Homer sells his stock in the powerplant and makes a cool $25. “Buy low, sell high,” he says. Homer’s got the right idea, and it sounds obvious, right? In practice, a lot of investors do the opposite. They buy stocks when they’ve been performing very well for a period and sell when they’ve been heading down. People get greedy for big gains when things are going well, and fearful of big losses when things are going badly. E.g. Recently we saw world markets plummet because of short-term Brexit panic. The S&P 500 recovered again within days. If you sold your shares out of fear, you’d be feeling like an idiot now.
It’s very tempting to try to “time the market” i.e. to latch onto that hot fund or stock at just at the right time. Trying to time the market is not a smart idea. You are likely to buy/sell at the wrong time and will get eaten alive by fees doing it.
I’ve talked about how KiwiSaver fees can hurt your returns. Trading fees do the same thing. You pay fees every time you trade (buy/sell) and these chip away at your returns. Like Jack Bogle, the creator of the index fund said: “Instead of trying to find a needle in a haystack it’s better to just own the whole haystack!”
“Invest”, don’t “speculate.” Investing is aiming to gain from the long-term returns of companies, “speculating” is trying to profit from short-term market movements.
There’s not much point trying to outsmart the stock market as the majority of the time you won’t be able to. Think about it – there are thousands of professional investors that spend all day buying and selling shares, the chance that you or I (or your fund manager for that matter) know more than them combined is very slim.
Imagine playing basketball against an NBA all-star like LeBron James or Steph Curry. You might hit a lucky shot or two, but you could never win over the long run. Instead of trying to beat the professionals at their own game, simply buy ETF’s which track the whole market like the NZX50 or the S&P500, this way you guarantee you get your fair share of market returns.
It doesn’t take too much time
Investing in index funds is not a particularly time-consuming exercise. You simply need to pick a few funds and invest in them regularly. Then continue to do this for a long period of time. This is called “dollar-cost averaging.” Investing the same amount consistently means you buy more shares when the market has gone down, and less when it’s gone up. This stops you from making a mistake trying to time the market.
Investing in index-tracking ETF’s is not something to do if you want to make a quick buck. Jack Bogle recommends you invest over a period of at least ten years (preferably more) as any less is far too risky as you don’t give yourself enough time for market returns to even out.
You don’t need a million dollars to get started
Smartshares, a New Zealand based ETF provider, requires only a minimum of $500 per fund to get started and you can do as little as $50 ongoing. You can set up a direct debit with a portion of your savings going into some cheap index funds every month. InvestNow, allow you to invest in a Vanguard index fund for a minimum of only $250. Sharesies, a brand new investment provider aimed at first-time investors, allows you to invest from as little as $10 per week!
If you’re interested in learning more about passive investment providers in NZ, check out some of my articles below:
- My thoughts on the Sharesies Beta
- Dean from Smartshares answers your questions!
- I chat with Anthony from InvestNow
- Breaking news: Simplicity releases new Investment funds
- I compare the fees of Smartshares and Simplicity
- Smartshares compared to Simplicity: Part two
Or, If you want to learn more about general investment strategy, check out one of the articles below: