Investing in Index Funds and/or ETFs – What is Index Investing and Why it Matters

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There are a lot of ways to invest. Yet one of our favourite ways to invest for long-term wealth building is via investing in index funds and/or ETFs.

What is indexing investing? More importantly, why might investing in index funds/ETFs matter to you?

Read on – to learn why index investing is important and why it’s an effective solution for your get wealthy eventually plan!

What Is Index Investing?

Your portfolio is much like a bar of soap. The more you mess with it, the smaller it’s likely to get.

At the macro level, you probably know you can be an active or passive investor. But this doesn’t mean there are not shades of grey involved. 

Active investors tend to try and beat market returns. Generally speaking, they try to capitalize on market opportunities, by taking advantage of market lows, or highs. Active investing is highly involved – it takes time, specialized knowledge and energy to do it well. Typically, active investors are seeking short-term profits. Traders, a form of active investing, can use various strategies to take advantage of market momentum or declines.

From a money management perspective, active investing is common because money managers are compensated for their expertise and strive to beat the market. Otherwise, some wouldn’t have a job!

They strive to understand client needs, such as providing diversification, retirement income or a targeted investment return. Money managers try and invest in a way that delivers those client needs, based on that expertise. Active investors can be successful in the short-term but are a rare species in the long run. Why? Any active money management strategy runs the risk of failing to compare let alone keep up with any established benchmark over time. For any active, frequent trader or investor to be successful, the investor or money manager would need some sort of accurate crystal ball. Last time we checked, nobody has one!

Passive investors tend to ignore market fluctuations per se and try to match market returns. Passive investors know that they have no magic crystal ball to accurately predict the future –  including the short-term gyrations of the market, so they don’t even bother. 

Passive investors know instead of timing their stock or fund purchases, frequently, they are better off getting invested and staying invested for years if not decades on end, in a diversified set of investments that matches their tolerance for risk along with their financial goals.

Passive investors know that through diversified investments (i.e., many companies from many sectors), that mimic an established benchmark, they are likely to obtain the returns of that benchmark by simply staying invested with time. These investors are not looking for a short-term edge because they know long-term, their wealth-building success depends on less trading, less commissions, and less active money management overall.

Here’s a phrase to remember:

Your portfolio is much like a bar of soap. The more you mess with it, the smaller it’s likely to get.

This means we believe many DIY investors must resist the urge to tinker with their portfolio. At Cashflows & Portfolios, at times over the decades, we’ve suffered (a bit) from this tinkering desire ourselves!

That’s why we believe the best way to resist that tinkering is to be an index investor. We own a significant amount of indexed products respectively in each of our portfolios for exactly that reason. 

Index Fund Definition

An index fund is a type of mutual fund or Exchange Traded Fund (ETF) that aims to mirror a particular market.

For example, equity index funds essentially contain a tiny piece of all the companies included in a particular market index. When you invest in an equity index fund, you’re buying a small slice of the entire market.

Continuing with the example just above, there are index funds that mimic the Canadian stock market, U.S. stock market, and international stock markets. There are also index funds that mimic bond markets as well.

In fact, there are many index funds that track many different markets of all shapes and sizes, but each index fund shares a similar goal: to match that particular market’s return with time.

Index investing is therefore simply the process of using index funds to build a passive investment strategy. Index investors decide which markets they want to invest in, how much of their money to put in each one, how often to re-balance their portfolio, and they utilize index funds to put that process in place.

Investing in Index funds vs ETFs vs mutual funds – is there a difference?

Yes. Read on!

Investing in Index funds vs ETFs

Remember an index fund is a type of mutual fund or Exchange Traded Fund (ETF) that aims to mirror a particular market – not all index funds are ETFs. Not all ETFs are indexed. Far from it.

Both index funds and ETFs basically aim to track a specific market, holding a set of securities. While index funds are passive, some ETFs can be active or passive. Recall that active money management usually means higher costs to you – the investor. 

ETFs trade like stocks, on an exchange – hence the name “Exchange” Traded Funds. But don’t let the “Traded” name fool you. ETFs don’t have to be traded. You can buy and hold the same ETFs for years or decades on end if you wish as part of a passive investing strategy we highlighted above. 

Some index ETFs are famously low-cost because they don’t need to be managed, the fees associated with them are largely non-existent because some of them are passive investment products that seek market-like returns less minuscule fees. They mirror the index they track. So, coupled with low to no investment minimums, some ETFs are understandably a popular choice among investors who may have a wide range of money to invest: some, more, or lots!

Investing in Index funds vs. mutual funds

Technically, an index fund can be a mutual fund but you already know that’s where some similarities end. Many mutual funds are designed by money managers to try to outperform the market they track by regularly rebalancing portfolios, selling and buying assets, and reinvesting assets where the money manager sees opportunities. Over time though, for the most part, buying and selling and seeking out opportunities is a losing game to the index the mutual fund may track. All that time and energy comes at a cost – that cost is passed onto you – the investor. 

An index fund by comparison contains all the assets in an index and holds them in the proportion to how they’re represented in the index. There is no active money management per se. Without worrying about active re-balancing and research needed to run an actively managed mutual fund, those savings are passed on to you – the passive investor.

Why is Investing in Index Funds so Effective?

Whether you invest in index funds or index ETFs, based on the definitions above, it seems like index investors are “settling” for market returns. That means, more skilled investors or money managers could achieve better returns.

That is actually correct. That’s what active management is trying to do after all – beat the market. Otherwise, why bother?

Well, despite some active investing working well for some, at least at the institutional/big-money management level near-term, we know that professional money managers are failing and failing badly over time.

According to S&P data, over the 10 years ending December 31, 2019, 89% of domestic equity funds and 65% of institutional separate accounts underperformed their benchmarks, net-of-fees.

That’s a BIG beat by the S&P 500 index!

So, in a nutshell, beating the market is hard, very hard over time, since it requires not only predicting the future but re-doing it over and over again. 

Read more in this amazing Vanguard study here entitledThe bumpy road to outperformance“. 

What is Index Investing and Why it Matters

Knowing that the market is flawed, bumpy in the short-term, often very irrational over a period of months, actually gives index investors an edge: since most investors including professional money managers, fail to beat the market over the long term, then a viable alternative is simply to invest in the market and ride it out. 

This means investing in a basket of equity index funds and maybe some bond index funds (the latter to ride out market volatility) and ignoring any bumpy ride along the way. 

That said, you can also consider a “core and explore” approach as we do at Cashflows & Portfolios:

  1. We own a basket of dividend-paying stocks (for income and growth), and, for our core,
  2. We own a few low-cost indexed funds to ride market returns.

By doing so we feel we are rather a passive DIY stock investors that use dividends to help us with our respective journeys – getting the “best of both worlds”:

  1. We get consistent and growing income from our portfolio, via dividends, to spend, save or reinvest as we please, and
  2. We get long-term wealth-building growth from our equity index funds using ETFs. 

Should you want to read more about these perspectives, do check out these posts in detail!

Is Dividend Investing Right for You?

You can build long-term wealth by considering some of these Diversified ETF Model Portfolios.

What is Index Investing and Why You Should Consider It

Here are a few takeaways from this post, and why you should index investing:

  1. The truth is that there are millions of people investing all the time. By folks thinking they are smarter than they really are, we know from various reports that “average investors” regularly underperform the stock market by 4-5%. That’s because of failed attempts to time the market. So our advice is: don’t bother. By being in the market and staying in the market, with a significant portion of your portfolio, you are essentially guaranteeing yourself market-like returns. So, with index investing, which simply seeks to achieve market returns, this is likely going to be MORE effective for you than most active management strategies over time.
  2. Consider the costs. One of the biggest reasons that index investing is so effective is also one of the simplest: It’s low-cost. Investing in Index funds are often the lowest-cost investments available simply because they don’t require a portfolio manager who needs to be paid to try and beat the market. You don’t have to worry about trading costs or portfolio turnover expenses that go into some of the more active strategies. Investing in Index funds provides an important assurance: to track the market. That simplicity keeps costs low, and those low costs are passed on to you in the form of higher returns.
  3. Many index funds are diversified by design. Diversification simply means spreading your money (and risk) around – you are avoiding all your eggs in one basket. For example, instead of buying just a few stocks to own in Canada or the U.S., you can own hundreds or thousands of them in the U.S. in particular for a very low fee. By owning so many companies, spread across sectors, you’ve essentially removed any single company sinking your investment portfolio. Of course, naysayers will tell also you that indexes include some of “the duds” in the market. That is true, but you’ll own all the “winners” or winners you never saw coming either. Many experts have considered diversification the only “free lunch” in investing because it’s the only way to decrease your investment risk without decreasing your expected return. 

Investing in Index Funds in Practice

Markets will always go up and down – at least we expect that from our knowledge of market history.

That is just one of the keys to investing success you can find and learn from here.

As the markets move up and down, there will always be people around you consumed with either fear or greed or anything in between. We suggest you ignore those voices as much as possible!

Instead, build a solid financial plan and investment plan that includes at least some low-cost, diversified index funds.

By investing this way, you will keep your investing costs lower, you will hopefully avoid tinkering with your portfolio, you can own tax-efficient ETFs to be tax savvy, and by staying invested you can ride long-term market returns for your get wealthy eventually plan.

Index investing is not without risk but at least there is no risk that some money manager is going to underperform the market on you through active money management. 

When it comes to investing success, consistency is key. Using an index investing approach and indexed ETFs can be part of the solution.

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