Index funds - a solution for the everyday investor

Not everyone wants to become an investing expert, to study markets daily or take on huge debts to become a property investor.

And if paying investment advisors does not guarantee better returns, what is one to do?

My recommendation is that most Australian’s would be best served by investing in a humble index fund.

To quote the legendary John C. Bogle in his excellent book (which I recommend everyone reads immediately) titled ‘The Little Book of Common Sense Investing’:

"History confirms that the winning strategy is to own all of the nation’s publicly held businesses at very low cost. By doing so you are guaranteed to capture almost the entire return that they generate in the form of dividends and earnings growth.

The best way to implement this strategy is indeed simple: Buying a fund that holds this market portfolio, and holding it forever. Such a fund is called an index fund."

Essentially, an index fund seeks to provide the return of the market, less fees. This is achieved by holding a portfolio of shares, which matches the index it is tracking.

In Australia, this is best illustrated by the Vanguard Australian Shares Index EFT (ASX: VAS) which seeks to obtain the combined return of the top 300 publicly listed companies in Australia (the index), less fees.

Here’s why indexing stacks up as an investing option:

• With one investment, you immediately obtain significant diversification. Diversification means less risk, less volatility, and smoother performance returns.
  

• Indexing is extremely low cost. For VAS, I’m talking about costs of 0.10% per annum low. Indexing is low cost because there is less human involvement in picking and selecting shares. For the most part, the indexing process is automated - the fund is simply buying and selling shares as they move throughout the index.
  

• The index is self-cleansing. This means that as a share increases in value, the fund will buy more to match its weighting in the index. As a share decreases in value, the fund sells down the share.
  

When you buy an individual stock, you are making an assertion that the business will continue to be profitable in the future, that the value of the company will increase over time. But as we know, owning a business is one of the most risky things you could ever do! Businesses change so rapidly. There’s market pressure, global competitors, online retailers, all competing for your customers.

What I personally like about index funds is that you are effectively saying that you are confident the Top 300 Publicly Listed companies in Australia will continue to provide profits, and will continue to grow in value over the long-term. I’m much more confident making this statement than picking individual stocks. Besides, even if all of Australia tanks, do you really think your individually selected stocks will be immune?

Overtime, different indexes have been created as indexing has become more popular. A quick glance now shows index tracking for small caps, property securities and ethically conscious funds. Personally, I stick to the classic funds and collect the total market returns.

Index investing may not be exciting. It may not be sexy when you tell your friends at the BBQ how you invest.

But move your ego aside and accept that if even the pros are unable to consistently beat the market over the long-term, what chance do you or I have?

If financial planners and fund managers are generally unable to generate returns in excess of their fees, why not accept the returns of the market and minimise fees as much as possible?

After all, indexing lowers risk while increasing returns - isn’t that what we all want?

How to make index investing work for you:

While indexing comes with the advantages of investing in stocks without as many disadvantages, there are still ways to optimise your investing.

Utilise dollar cost averaging:

Dollar cost averaging is an investing approach where an investor continuously purchases shares over time.

Generally, the shares would be purchased based on a regular routine, such as every 90 days, or when you have $5,000 saved.

With dollar cost averaging, it’s more about the discipline of regularly buying stocks, rather than trying to time the market by buying when prices are low.

As a result, less shares are purchased when the market is high, and more shares are purchased when the market is low.

Dollar cost averaging ties in nicely with the financial principle of paying yourself first. If you don’t have the money, you won’t miss it.

As a purchase of a parcel of shares will entail brokerage costs, for most people I’d recommend purchasing once a month. This means you have a sizeable amount of cash to invest and once a month is regular enough to take advantage of dollar cost averaging.

For those with less to invest and looking to minimise brokerage costs, investing every quarter is fine too.

“It’s time in the market, not timing the market”

When most people think of investing, the classic philosophy of ‘buy low, sell high’ generally comes to mind.

What has now come to transpire over years of research is that, most people are terrible at this!

There are only a select few that can consistently beat the market, and unless your name is Warren Buffet, there’s a good chance you are not one of them.

Not only this, but history shows us that the majority of investors would have received better returns by simply buying an index fund, and holding it through the ups and downs of the market.

Over the long-term, the ASX has never failed to increase in value. Yes, it has taken time, but it has never failed to achieve new highs. This is also what I love about index funds - you collect the total returns of the market, a share of businesses that are continuously trying to grow their revenue and business value.

While the market has never failed to increase in value, the same cannot be said about individual shares.

Even if you invested the day before the GFC hit, your investments would not only have increased in value by now, you would have also picked up a lot of quality shares at low prices if you continued to buy consistency along the way and reinvest your dividends. These investments would have grown significantly in value by today’s date.

Reinvest dividends for automatic wealth creation:

When you invest in shares, more often than not you will have an option of utilising a Dividend Reinvestment Plan (DRP).

This means that rather than being paid the dividend in cash, the dividend is instead used to purchase more shares in the company.

The benefits to this are:

• There are no brokerage fees when reinvesting

• Your dividends aren’t being received and therefore can’t be spent

• You are automating your wealth

What we tend to find is that those that utilise the DRP option don’t miss the money, and their investment goes up considerably in value over the long-term because they are constantly reinvesting their dividends to acquire more shares. More shares acquired, means more dividends in the future. As dividends continue to grow, you continue to acquire more and more shares, providing more and more dividends - a massive compounding return over the long-term.

Reinvesting your profits is the true way to take advantage of compounding and have your wealth grow.

Tax tip: Even though you didn’t receive the dividend as cash, you still need to declare it in your tax return.

Utilise a mix of international index funds as well

As the Australian sharemarket makes up such a small proportion of the world’s economy, it makes sense to diversify your investments into other countries.

Not only this, but the world’s biggest companies (think Apple, Google, Microsoft) aren’t even listed on the Australian Stock Exchange, so you’re not only missing out on their returns, but also the future up and coming players.

The good news is you don’t need some fancy stock broker to invest in overseas companies for you. There are many ETFs available for purchase on the ASX that allow you to access the returns of some of the biggest companies in the world.

For me, indexing makes a lot of sense. Ultimately, it is my goal to have the majority of my share portfolio in index funds, complimented by a small selection of personally selected companies that I believe in.