I was always a bit skeptical about the stock market. I was scared to invest in individual stocks – it all felt a bit too risky. I didn’t want to put all my eggs in one basket.
Disclaimer: The information in this blog is my personal opinion and experience and is not legal or financial advice in any way! Also, just FYI, this post may contain affiliate links.
When you get a spare 15 mins, I’d highly recommend having a quick listen to these book on your Blinkist app!
Both books talked about the importance of making your money work for you by spreading your risk. The books introduced me to the beauty of index funds (or “Exchange Traded Funds”).
What is a fund?
Most people have heard of actively managed mutual funds. These are funds that are managed by a finance professional.
Money is pooled by investors and the fund manager “actively” buys and sells the shares with the fund.
This requires the fund manager to speculate (i.e. guess!) when the best time to sell or buy is. This guesswork is risky because the market is the economic response to human behaviour.
And human behaviour can be very unpredictable!
Actively managed funds are also mega expensive. And fund managers get paid whether you profit or not.
Most people invest in actively managed funds unaware of the implications and the high costs and sign up because of a slick finance professional in a fancy suit.
A 2% yearly fee can take a good 2/3 of your profits. Ouch!
What is an index fund?
An Index fund (or an Exchange-traded fund (ETF)) is different to an actively managed fund.
An ETF holds a diversified portfolio that reflects a market index. For example, a FTSE 100 index fund or ETF would hold a share in each company in the FTSE 100 index.
This essentially means you can invest in an entire market with just one security.
It’s like betting on a casino rather than individual horses. So it doesn’t matter which horse wins. The house always makes money.
ETFs are traded on a stock exchange, just like shares. You can buy or sell ETFs during trading hours, just like shares.
What makes index funds special
Compounding is when interest builds interest.
Index funds are expected to grow by 8-10% on average each year.
Essentially, this would mean that a £10,000 investment at 10% interest would become £11,000 after the first year. That extra £1,000 would itself earn interest the following year… and so on.
This would keep happening year after year. So after 30 years, that original £10,000 would become £175,000.
I initially thought that holding funds indefinitely and not selling when high and buying when low might result in missed opportunities.
But based on historic data, the long term the highs and lows of the market tend level out.
John C Bogle’s Little Book of Common Sense Investing provides some great insights on this.
2. Low fees
Compounding wouldn’t be so effective if it wasn’t for low fees.
Actively managed mutual funds usually come with high (often hidden) fees. These include brokerage fees plus management fees.
Conversely, an index fund is a passive fund so it doesn’t require management. This means no fund management fees. Yay!
Simply put, lower fees means that you keep more of the profits.
To keep fees at a minimum, I quickly realised that it’s is important to select the right brokerage with fees of no more than 1.5% ideally.
3. Hands off and low maintenance
The main reason I was scared to invest in individual stocks was because I could never be sure I’d be buying the shares at a good price.
I knew that if the actual value (i.e. the price I’d pay) was less than the intrinsic value (i.e. the true value of the stock), then I’d be getting a good deal.
But I also knew that the only way to be sure of the intrinsic value would be to do a hell of a lot of research into the company.
Then, to make this a success, I’d have to compulsively measure and monitor my investments so that I’d know when to sell in order to make a profit.
Lawyers work long hours! I simply didn’t have the time!
This is why Warren Buffet advises those who don’t have time to compulsively track the market to invest in index funds.
4. Diversified to spread the risk
I knew that investing in a single company meant betting on that one company to be successful.
As most of us lawyers are, I’m pretty risk averse – so the concept of “betting” on one company gave me anxiety!
For me, this is what makes index funds / ETFs really special. Because when investing in an ETF it basically meant betting on all of the companies on the market, rather than just one.
So this spreads my risk, meaning a single failure won’t wipe out my investment.
*sign of relief*
This is why Benjamin Graham encourages everyone to diversify and never put all your eggs in one basket.
5. Transparent without speculation
Another thing Benjamin Graham encourages in his book, Intelligent Investor, is to avoid speculation.
This is what actively managed funds involve: speculation of what the market will do next.
There is no speculation or active management with an ETF. So I know exactly where my money is invested.
An ETF doesn’t guess the market. It holds for the long term, without the risk of betting on individual stocks.
6. Liquid and flexible
ETF’s aren’t subject to a lock-in period or penalty fees. This means that I can buy and sell them at any time.
This is unlike actively managed mutual funds, which often restrict people from accessing their money for years.
With ETF investing, it is possible to “do it yourself”.
I love this because I can be a bit of a control freak at times. I like to know exactly where my money is.
So many financial advisors I spoke to talked a good game, but when it came to crunching the numbers, their explanations quickly became opaque.
So, I went on a mission to learn the basics.
After some online courses and reading books like Andrew Hallam’s Millionaire Expat, I was ready to set up a brokerage account and do it myself.
Now, I won’t lie – it wasn’t always easy.
I had to work on my mindset first to understand that:
- when the markets drop (like they did during the pandemic) that is the time to buy more; and
- when markets rise, that is the time to sell or hold.
Many people do the opposite of this. So it can be difficult to not “follow the crowd”.
I have trained myself to understand that market downturns essentially mean I’m buying the stocks on sale. And I love a good sale!
Keeping money in the bank might seem sensible. But money in the bank will depreciate year on year. This is because inflation is higher than the interest received.
Actively managed funds are risky, expensive and frequently underperform the market.
Index funds / ETFs are good because they:
- attract compound interest, which is the process of continually investing gains so that those gains earn gains (and which is why Einstein called it the 8th wonder of the world)
- have much, much lower fees than actively managed funds;
- don’t require much effort or maintenance – I can just invest and watch them grow;
- are diversified by nature and so spread the risks;
- are transparent so I know exactly what I’m investing in;
- are liquid so I can take withdraw my investment whenever I see fit; and
- are easy to get to grips with – so I can be a DIY investor and manage my control-freak tendencies.