Finance: Investing in Indices

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If you don't have serious time to sink into figuring out what stocks to get, there's a simple way to invest and forget. Fire and forget.

It's not a gimmick and it will always pay off (historically) if you do not need your money soon... in a few years, or 10 years.

How Not To Invest

Back in the 1980s, I and Wendy thought ourselves bright and forward thinking to seek out a broker. (Long before the Internet, it's how it worked.) We went to a local Richmond, Virginia investment firm (Branch Cabell) who praised Warner Communications. In my mind's eye, I see an young eager couple with a few thousand dollars, trying to be wise, entrusting our money to a very sure lady there.

But Warner Communications sank badly. Later, there was a class act about how Warner itself duped investors. We got a little back, but... pfft.

There is a way to avoid the problems with any one stock. This way is to invest in a stock index. Stock indexes (indices) are an average of wide swathes of stock. They can be the same as saying, "I believe that the United States will continue to be strong", if you invest in an U.S. index stock. If the entire market goes down, you do. But you are never beholden to one company's stock taking a dive. And historically, the stock market - and its indices - do very well. Perhaps 7%, as a long term average. Often far better (!) but sometimes poorly, in the short term.

How do index funds work?

A stock market index tracks the stocks of a large number of companies. If you put the average of 100 stocks together, that makes an index.

A mutual fund is a way to combine a number of stocks together. As a general term, it doesn't have anything to do with a stock market index. You will see long lists of many types of funds, on investing sites. Some mutual funds track indices. That's what I'm talking about.

A stock market index fund is a way to track an index, like the Standard and Poors' 500 index (Wikipedia). This tracks the 500 largest U.S. companies. It is usually considered a mid-cap stock, although strictly speaking, it is both large and mid-cap stocks.

Large, middle, and small capitalization means the amount of money a publicly-traded company has in the stock market. You multiply all its shares by the amount each share is worth. The Dow Jones Industrial Average tracks the 30 largest companies, the S&P 500 the 500 largest ones, etc.

Why are index funds a great way to invest?

The words of Jack Bogle written long ago still inspire: Invest in the entire market at the lowest expense possible. He is the grandfather of the index fund.

If you do not have time to worry about individual stocks, then DON'T WORRY ABOUT INDIVIDUAL STOCKS. Invest in the entire market. Make your risk be the same as for the entire market, or a large share of it. It's easy with index funds because you are not buying any one stock, you are buying a part of every company that is tracked by a particular index fund.

For example, by definition, if you invest in an S&P 500 index fund, you are buying stocks of the 500 companies that are indexed, in an amount equal to their market capitalization (more to bigger ones, less to smaller ones, in those 500). Your fund is coming very close to being just like the index, although there will always be tiny differences because it can't quite mimic every single change to the ways the index are classified, plus there's always a slight management fee (keep it well below 0.50%, the lower the better).

These funds have an important stealth benefit that, because they passively track an existing index, all that the fund's managers have to do is mimic how that index is composed. It's actually slightly more complicated than that, but this is close enough. The opposite is called an actively managed fund, where the managers try to accomplish certain goals that are not tied to an index. They may try to outperform the market (i.e., indices) by being smarter. Or they may specialize in tech stocks, eco-friendly stocks, or whatever.

Because index funds are passive, the managers only have to reflect the stocks that make up an index. It's pretty simple. As a result, the management fees are usually much lower than for actively-managed funds. Index funds might have fees from 0.5% a year to even less than 0.1% a year. Actively-managed funds might be 1% or 2%. When you consider that stock market averages might be 7% or so, you can see that anything eating into this percent is a serious matter. When management fees are stated, something like 1% doesn't mean 1% of 7% (multiplicative). It means 7% minus 1% which equals 6%. When you take into account compounding across years, it's a very serious fee. You would like it below 0.5%. As close to 0 as it can get.

How the entire market has performed

You can go to somewhere like Yahoo can download how the S&P 500 index has performed since its inception. Set the output to weekly prices (or whatever), then all that download to a spreadsheet. Set it up so you seeing a moving comparison of each row versus 10 years ago (or whatever interval you choose). It's not hard to do if you are comfortable with spreadsheets.

You will find that indices (and the stock market) historically always do very well across any long period of time, defined as something like 10 years. Even if you play devil's advocate and start with the worst dips, it always does great over long periods of time (perhaps 7%). For every time you are tempted to say "but it can do worse", remember that this average means, half the time it did better than that.

Worrying about investing in a broad index like this is the same thing as asking if the world will melt down, or not. If the whole world melts down, there will not have been much you can do aside from not investing. If it really gets that bad, it may well not matter where your money is anyway. If it doesn't melt down (which it hasn't ever yet), you are missing out on solid gains over time.

Just remember, think long and hard before withdrawing your money if the market is down. The question is not, "has the market been down a long time?" (like it was circa 2009). The question is, is the United States really completely in free fall? It was not in 2009. Hell, if the world is really coming to and end, it may already be too late. For anything or anyone.

But if it's just a serious down time (like 2009), keep in mind the investing mantra: Buy low, sell high. DO NOT withdraw when low, because in one sense, you have already had the foresight to buy in low (cough). And are simply waiting for it to rise again.

Market timing is not recommended except for the very serious truly full-time pros

Around 2000, I took a $6000 IRA and tried being a day trader. This is a person who actively watches stocks and might buy a bunch one minute, only to cash out an hour later if the stock does well.

I did hundreds of trades on hot stocks over the course of a few months and, while it was exhilarating at times - I was once up 50% in 90 minutes - in the long term, all the trading fees took their toll. When I sobered up and realized I was at $3000, I did a full stop.

I strongly recommend against day trading or almost any kind of market timing. It's okay for people whose full-time job (or serious hobby) is tracking companies and markets. But if you don't truly have that kind of time, keep it simple. Invest in an index.

Invest in a particular company or sector if you feel very confident

But do it at your own risk. Today's winners are tomorrow's losers, eventually.

Small Caps versus the S&P 500

I don't recommend investing in the Dow Jones Industrial Average, because it is a weighted average of the 30 largest U.S. stocks. Too susceptible to one of those companies having a problem.

The S&P 500 is the 500 largest stocks. This is much more breathing room. It is in effect, the largest plus the mid-capitalization stocks.

There are other indices that also include small caps, or exclude larger companies and focus on small ones.

If you chart stock indices over long periods of time - many years - you will see that they basically perform quite similarly. But there is one important difference: Smaller indices have more variation. They go down farther when the market goes down, and rise more when it comes up.

The upshot is that if you want to stay invested for the long run, but want to play the market just a little, consider switching to small-cap indices (with very low management fees), and when it's high, switch to mid-cap indices or S&P 500 indices. In other words, catch the one that swings the most, when it is nearest bottom. Then when the market crests, switch to the one that doesn't fall as far.

I am talking about very obvious market tops and bottoms... the kind where, if you look at a chart of the last 10 years, you can tell if it's near a bottom for those years, or a top. As of this writing (May 2017), it is obviously near a top in these terms. So it's time to be in mid-caps.