Throughout my posts on The Money Spot I have always said that personal finance is personal.
So when I had a very interesting conversation with a coworker telling me that index investing is wrong and I should be buying solid gold and silver bars instead. I was a little taken back as I had never heard the following ideas before ” If the American dollar is not tied to oil anymore it will collapse” or “Their money used to be backed by gold and silver reserves in the Federal Reserve and now there is nothing” and “If the collapse happens the value of gold will increase seven fold.”
It was all very interesting stuff. The thought of the pieces of paper we know as money today being eventually worthless. Therefore being required to barter with gold or silver bars to purchase or sell anything. All this was something I never considered before. So the thought of buying gold & silver bars and stashing them away for an investment strategy was completely new to me. Therefore I am not very educated on this subject matter to know if any of this is true, wise, or even possible. I didn’t have much to add to the conversation so it ended rather quickly. And I wasn’t about to get into an argument as anything could potentially happen in the future.
After our conversation, it caused me to think about my own investment approach being an index investor and if that situation was to ever occur. How would my index investment approach handle it?
I thought about it last night and as I write this post I honestly think even if something like this was to happen, I would be just fine. Being invested in 6422 different companies amongst United States, Canada, International, Emerging Markets, and Real Estate. I feel confident that the majority of those businesses will still or adapt to be able provide services to consumers and be profitable to shareholders.
In the event that this isn’t the case and I lose all my money invested in my index funds. I figure I’ll have much bigger worries on my hands. Like trying to survive then worrying about the money I recently lost.
That conversation did make me decide to write about the 4 reasons why I’m an index investor. I won’t try to get all pushy like the conversation I had last night and start saying other investment approaches are wrong. These are simply my reasons and hopefully the activity in the comment section will highlight the positives and negatives of index investing along with different investment approaches. As there are many different investment paths available to meet your investment goals. Hopefully this conversation will help novice and veteran investors decide what is best for them.
The 4 Reasons Why I’m An Index Investor!
What Is An Index Fund?
An index fund buys an holds a broadly diversified basket of stocks that match the holdings of a market index. Meaning when you buy an index fund you own the entire U.S., Canadian, or International stock market depending on which index fund you buy. Index funds do very little trading compared to actively managed funds. Because of this there management expense ratio are commonly lower. So in this sense you are buying the entire market when you purchase an index fund. You are not eliminating market risk, you are simply riding the market returns up and down as you are a creature of the market.
What is a market index? The best way I remember it being described to me that we can all relate to goes as follows. Imagine you enter a 5km race with 50 other participants. The average time to complete the 5km race was 25 minutes. Meaning for every participant who crossed the finish line one minute faster then 25 minutes there was another participant who crossed the finish line one minute slower. Financial markets are very similar. For every dollar invested into an investment which has better returns then the market there will be another dollar invested into the market which lags behind by an equal amount. So in that sense, when you invest in an index fund whose goal is to track the market index you are trying to receive the average market returns for that year. A lot of people get turned off when they hear average returns but it is very important not to get discouraged about receiving average returns as I’ll explain in the results section below.
There thousands of market indexes amongst the stock market. The market indexes my index funds track include “S&P/TSX Capped Composite Index, CRSP US Total Market Index, FTSE Developed ex North American Index, or FTSE Emerging Markets Index”.
Low Management Expense Ratios (MER)
When I first started investing I invested in mutual funds. Now I’ll be the first to admit that not all mutual funds are bad investments. They have there own unique benefits and downfalls that we will discuss another day. In fact I find some of them such as “TD E-Series” a very attractive investment option. The mutual funds I was invested in, the magic of compound returns with investing were being overwhelmed by the effects of compounding costs due to high management expense ratio my funds carried.
To illustrate how crucial costs are to the equation mentioned above. Lets look at this following example. Assume you compare two investments over a 50 year time span were you invest $417/month. One with an investment return of 7% and another with an investment return of 5% as 2% of the investment return was going towards paying the 2% management expense ratio.
You will see that the 2% management expense ratio over a 50 year time span consumed 50% or 1/2 of the returns when compared to the 7% investment. This is what I mean when the magic of compound returns with investing are being overwhelmed by the effects of compounding costs.
The average management expense ratio (MER) on the index funds in my own investment portfolio are 0.20% to 0.50%. Which are much lower than 2%. On $100,000 investment portfolio the difference between a MER of 0.50% and 2% is $1,500 annually a year.
Which I believe raises this question? Do you really want to invest in an investment option where you front a 100% of the capital to own the investment, take 100% of the risk and potentially receive 50% of the return?
I own five index funds which have United States, Canada, International, Emerging Market, and Real Estate exposure. Owning these four index funds I have a stake in 6422 different companies across the globe. This level of diversity allows me to sleep easy at night knowing the chances of 6422 going bankrupt and me losing all my money invested is low.
Managing my investment portfolio is very simple. I have decided upon a target allocation for my five index funds (22%, 22%, 22%, 22%, 12%). Every time I have additional capital to invest, I purchase additional shares of whichever index is lagging behind my target allocation. This way I am always purchasing the index which is lower in value. Bringing my actual allocation closer to my target allocations for my investment portfolio. Rebalancing my investment portfolio this way maximizes my chances of achieving the best long term returns possible with the index funds I have.
It is always important to remember the saying past performance doesn’t guarantee future results. There will also be the occasional few investors who are able to beat the market on a regular basis. But the vast majority of us will be unable to do so. Which is largely why Warren Buffet is so popular. Remember above how I mentioned investing in an index fund you are receiving the average of the market return for that year? It is important to realize that these average returns are far from average when you consider them over a ten year and longer time frame. It has been proven time and time again that investing in index funds over that length of time frame your accumulated average return will be amongst the top 10% of investment returns that decade.
These are the reasons I believe that investing in index funds provide me the best chance of reaching my financial independence goals. Being able to get wall street, trading, and to an extent management expense fees out of the equation will improve my long term investing returns.
What is your personal investment strategy? Let me know if you have anything to add, agree, disagree on, so we can provide the best investment advice possible.
Long: XIC, VUN, VDU, VEE, ZRE