The key to successful investing is understanding your objectives, investment horizon, funding capability, and risk tolerance.
This is true whether buying a stock in a single company or an index fund covering companies around the world.
Many people treat investing as wagering, making a bet on a horse race or buying a lottery ticket and hoping for instant wins.
Others fail to recognize the risks that accompany their investment choices or the benefit of compounding returns over years of patience.
Financial experts agree that index fund investing is the best place for most investors, especially those who lack the time and expertise to closely monitor their holdings.
Many mistakenly select volatile investments without the psychological or financial capability to weather the price fluctuations, rapidly swinging from glee to despair.
The purpose of this guide is to help you make the best choices for your specific situation.
The first step on the path to financial independence is the recognition that you are unique. The cookie-cutter advice prevalent in financial magazines and newspapers or broadcast to the multitudes by slick promoters of investment snake oil is not for you.
Implementing the following process will ensure that investment decisions are well-considered and appropriate for you.
Table of Contents
Step 1. Know Yourself
Wall Street firms attempt to put round pegs into square holes with a one-size-fits-all approach. The average investor rarely pays sufficient fees to justify the personal attention of a Wall Street firm or investment adviser. Unless you have considerable wealth and are willing to pay significant fees, you – and only you – are responsible for investment results. Only you can decide whether your results mean “success.”
Investment Objectives
People generally save for a specific purpose, perhaps building an emergency fund for future pandemics, a possible loss of a job, buying a first home, paying for a child’s college, or retirement.
Many hope to achieve multiple savings goals over their lifetime. Have you considered what you will do with your accumulated savings and how much you will need to meet your objectives?
Understanding why you are saving – your goals – enables you to prioritize their importance.
Having an emergency fund available for unexpected disasters is a greater need for most people than a college fund.
The difference in importance naturally affects the type of investments appropriate to meet the goal.
Since an emergency can appear at any time with unknown consequences, savings should be invested in low risk, low volatility assets to be sure funds are available when needed.
In contrast, buying a new house can be delayed indefinitely if the need arises.
The lack of an immediate need means that funds for a house down payment can be invested in higher risk areas with higher returns.
Whatever your investment objectives, taking the time to clarify them will help you make the right investment decisions for you.
Investment Horizon
Investment values generally compound over time – the longer your money works for you, the greater the ending balance.
For example, investing $100 per month at the S&P 500 average rate of return for the past century (9%) per annum will build a savings of $19,495 in 10 years. At 20 years, the balance will grow to $67,285, and in 40 years, $471,616.
Your investment during the period is $48,000. Clearly, time is on the side of those who have years ahead to reach their objectives.
The value of your ending account is the result of your investment ($100 per month, in this case), your earning rate (9%), and the investment period (40 years).
For example, if you raised your investment to $200 per month over the 40-year period, the ending account balance earning at the same rate would be $943,232.
How does the length of investment period affect your investment choices?
Risk and time of investment are generally positively related: The longer the investment period, the lower the risk of loss.
The logic seems counter-intuitive until you recognize how emotions drive prices in a free market in the short-term:
- Gasoline. In the 1970s, the OPEC nations cut oil production and prices exploded upward due to panic that gasoline would not be available. In the United States, many people spent hours burning fuel looking for open service stations. While prices rose, supplies quickly grew to reach demand.
- Toilet paper. During the 2020 Covid-19 crisis, stores could not keep rolls of toilet paper on the shelves as people rushed to hoard them expecting supplies would run out.
- Stock prices. Investors are especially vulnerable to over-reaction. The impact of their fears is multiplied by the extensive use of automatic ordering systems designed to limit loss.
Fortunately, over the long term, logic and reality always win out.
An investor in the S&P 500 might feel akin to a rider on the Texas Tornado roller coaster on a year to year basis.
From 1927 to 2019, the S&P 500 lost value twenty-eight of the ninety-two-year period (almost one-third of the time).
The record is better as the holding period increases. Less than twenty percent of investors in an S&P 500 index fund would have had a negative return after a 5-year holding period while anyone with a holding period of ten years or more would have enjoyed a gain averaging more than 9% annually.((S&P 500 Historical Return Calculator))
How should your expected holding period affect your investment decisions?
When a friend tells you about a risky investment that might double your money overnight, consider its impact on your objectives.
A $5,000 investment has different consequences if you are 35 with years of potential raises and promotions ahead of you than if you are an older employee and expecting to retire in ten years.
A younger person might be able to recover from a total loss while an older investor will suffer a significant setback.
Funding Capacity and Pattern
When and how much to invest should be considered when you decide which investment to make.
Some people invest in large sums of money at irregular times, such as inheritances or bonuses.
Others regularly set aside a specific portion of their regular income.
One-time investments expose you to the timing risk of market volatility. Since you can never be 100% sure of the future direction of the stock market level or the stock price of a specific company, the risk of buying at the top of a market or selling at the low point is always present.
The prudent method to invest large sums is to copy the system used by the investor who consistently and regularly invests over long periods.
Dollar-cost averaging is a popular method to ensure you get the benefit of average prices when buying or selling over an extended period.
You give up the opportunity for maximum gains but reduce the risk of major losses due to timing of your purchases.
For example, Joe T. saves and invests $100 each month.
He wants to buy shares in ABC Index Fund that is selling for $12 per share.
On month 1, Joe invests his $100 and receives 8.33 shares of the fund.
When Joe invests $100 the second month, the share price has fallen of $9 per share so he buys 11.11 shares, bringing his total to 19.44 shares with a total cost of $200.
The third month, the share price has recovered and sells at $13 per share.
His $100 buys 7.7 shares. At the end of three months, Joe has 27.14 shares for a cost of $300 or $11.05 per share.
The total market value of his owned shares is $352.82. If Joe had invested the three $100 initially, he would have 25 shares with a market value of $325 today.
Risk Profile
Your risk profile illustrates your capacity and tolerance to assume risk:
- Capacity: The ability to absorb a loss or setback without affecting one’s lifestyle, physical health, or mental stability varies from person to person and from one type of risk to another. For example, professional golfer Phil Mickelson reportedly lost $2.75 million gambling in 2010. For most people, a loss of that magnitude would be physically and mentally devastating. In Mr. Mickelson’s case, it represented a small amount of his reputed $30 to $40 million annual income. Mr. Mickelson has a significant capacity to take financial risk. Before voluntarily assuming a risk, you should always ask, “Can I afford the loss if it occurs?”((Millions from Phil Mickelson tied to money laundering, gambling case))
- Tolerance: What is your attitude toward risk? How comfortable are you taking risks? Our willingness to assume a specific risk is directly correlated to our knowledge of the uncertainties associated with it. The more we know, the better we understand; the unknown becomes known. For the same reason, extreme sports athletes, soldiers, police officers, and firefighters undergo intensive training and hours of practice in different scenarios to identify, understand, and anticipate the risk they might face in real situations. When faced with a situation that might lead to loss, ask yourself: “Do I want to take this risk?”
A person who is required to assume more risk than they can afford or psychologically accept will experience anxiety and physical.
Furthermore, risk tolerance is as variable as applying sunscreen; it depends on the weather. In other words, your willingness to take risks changes as your circumstances change. Even a rough understanding of your capacity and tolerance for risk is better than no understanding at all.
Step 2. Select the Index that best fits your profile
There are more than 5000 indexes in the United States alone.
Some track large sectors of the stock market while others are limited to specific geographical areas, capital structures, and industries.
In selecting the index that best fits your needs, consider that as the index becomes more specialized or covers smaller groups of company (a specific industry or geography), potential returns, and risk increase.
For example, the S&P 500 index fund has less volatility (fluctuations in price) than the Dow Jones Industrial Average due to the greater number of companies (500 vs. 30), even though there is an overlap between the two indexes.
In the same way, selecting an index fund that tracks a single sector or industry exposes the holder to more upside and possibility of loss than an index that covers multiple industries.
The following is a snapshot of different indexes that track different groups of securities. Each index represents a different risk/reward combination so investors can choose which index best fits their individual objectives and profile.
A sample of indexes of different types include:
Broad U.S. Stock Market Indexes
- Standard & Poor’s 500®. The companies within the index represent about 80% of the total U.S. stock market value. Each stock in the index is represented in proportion to its total market capitalization.
- Dow Jones Industrial Average®. This price-weighted index follows the combined shares of 30 of the largest and most influential companies in the United States.
- Nasdaq Composite Index. The index tracks the composite of all stocks traded on the Nasdaq stock exchange including some non-U.R.-based corporations.
- Wilshire 5000. This index represents each of the publicly traded companies based in the United States.
Large-Cap Indexes
Large-cap companies are those publicly traded corporations with a market value greater than $10 billion. A sample of the indexes that track this group includes:
- S&P 100. A sub-set of the S%&P 500, the index is the composite price movement of 100 major blue-chip companies in the U.S.
- MSCI USA Large-Cap. The index tracks the prices of 296 large U.S. companies in multiple industries.
- Russell 1000. The index covers 1000 U.S. companies that represents approximately 92% of the U.S. stock market.
Mid-Cap Indexes
Mid-Cap companies have market capitalizations (market values) between $2 and $10 billion.
- S&P Mid-Cap. The index tracks 400 U.S. companies in different industries.
- Russell Mid-Cap. Tracking approximately 800 U.S. companies, the index represents about 31% of the larger Russell 1000 companies
- Wilshire U.S. Mid-Cap Growth. The Wilshire US Mid-Cap Growth is a float-adjusted, market capitalization-weighted derivative index of the Wilshire US Mid-Cap Index.
Small-Cap Indexes
Small-Cap companies are those publicly traded corporations with market values between $300 million and $2 billion.
- Russell 2000. The index tracks the aggregate price of approximately 2000 of the U.S. smallest securities and represents about 10% of the larger Russell 3000 index.
- S&P 600. The index is designed to measure the performance of 600 small-sized U.S. companies with a market capitalization between $600 million and $2.4 billion, a float market cap of 300 million shares, and positive over most recent quarter and year.
- Dow Jones Small-Cap Growth Total Stock Market. The index is designed to measure the performance of approximately 1700 small-cap U.S. companies in multiple industries.
Industry Sectors Indexes
This group of indexes is designed to reflect the performance of publicly-traded companies in specific industries.
A sector index fund is likely to have greater volatility with potentially higher returns and greater risk of loss than a fund that tracks a broad-based portfolio with securities of companies in multiple industries.
- S&P Financial Select Sector. This index tracks the performance of 66 companies of the S&P 500 portfolio. Each company in the index is in the financial services industry.
- S&P Health Care Select Sector. This index tracks the performance of 61 companies of the S&P 500 portfolio. Each company in the index is in the healthcare industry.
- S&P Technology Select Sector. This index tracks the performance of 71 companies of the S&P 500 portfolio. Each company in the index is in the technology industry.
Geographical Indexes
Geographical indexes track groups of securities based in specific regions or countries of the world, generally excluding the United States.
- S&P Asia 50 Index. The S&P Asia 50 Index is a stock index of 50 Asian stocks listed on the stock exchanges in Hong Kong, South Korea, Singapore, and Taiwan and included in the S&P Global 1200. The index includes companies.
- DAX 30 Index. The DAX 30, or DAX Index, is a German stock market index comprising the 30 biggest companies trading on the Frankfurt Stock Exchange (FSE).
- EURO STOXX 50. The index covers 50 stocks from 8 Eurozone countries: Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg, the Netherlands, and Spain.
- Nikkei 225. The Nikkei 225 is comprised of 225 stocks selected from domestic common stocks in the 1st section of the Tokyo Stock Exchange.
The twenty-one indexes identified in this guide is not intended to be a recommendation of any specific index, but a sampling to show the scope and diversity of choice an investor has in selecting an index fund which best fits their objectives.
To discover additional indexes, search the internet using your favorite browser with the terms “index fund types,” “[name of country or sector] index funds,” or “major index funds.”
Step 3: Select Your Index Fund
Several investment management companies offer index funds intended to track the same index.
For example, an investor who has determined that a fund that replicates the performance of the S&P 500 index can buy funds managed by Fidelity, State Street, Vanguard, T. Rowe Price, USAA, and Charles Schwab.
Even though each sponsor intends to match the performance of the underlying index, there can be a significant difference between the results an investor might receive.
The difference in performance is due to three factors that you should consider when deciding about the right fund manager to track your chosen index:
Tracking Error
The difference between the performance of an index and an index fund intended to clone the results of the index is called “tracking error.”
For example, the index goes up 10% while the index fund increases 9.5%. the difference – 0.5% – is the tracking error.
It is impossible for an index fund to perfectly replicate an index for several reasons:
- Cash holdings. Funds must keep a portion of their capital in cash to be able to redeem or cash out shares when presented. Consequently, the fund is never fully invested. Holding 1% of the fund’s value would mean that, at best, it would produce 99% of the fund’s performance. The cash is a benefit in down markets and a drag in bull markets.
- Rebalancing lags. As the price changes of the underlying securities in an index impacts the composite value, fund managers must make a minor adjustment in the fund portfolio, much like an automobile driver on a rough road. The corrections always lag actual results to some degree, even with the help of A.I.-enhanced execution systems.
Expense Ratio
Financial management systems are not charities, providing valuable services to investors through the kindness of their corporate hearts. With few exceptions, each fund manager collects a fee for administering a fund and recovering necessary third-party costs necessary for fund operations.
Actively managed mutual funds typically have annual expense ratios between 1% and 2%.
Passive index funds generally have much lower ratios – around 0.2% – reflecting the lower liability and expenses of analysis. Some investment managers offer 0% expense ratios index funds for large investors.((Zero expense ratio index mutual funds))
Commissions, Redemption, and Other Costs
While many investment firms offer index funds without charging a front-end fee, a back-end sales commission, or a redemption fee when you liquidate your shares in the funds, it is not a certainty.
In addition, many charge “account fee” each year.
Before buying any mutual fund, read the sales material and account information before agreeing to the transaction. Always follow the dictum “Better Safe than Sorry” when dealing with financial matters.
Minimum Investments
Some index funds require minimum investments to buy shares or receive advertised discounts.
Be sure that the fund you select permits your level of investment.
Significant difference in investor results between sponsors tracking the same index is possible.
Be sure to do a comparison of (1) tracking error rates, (2) expense ratios, and (3) transaction and account fees.
Step 4. Buy Index Fund Shares
You have completed your homework and decided which index fund best fits your needs, leaving just one last step – acquiring the shares of the chosen index fund.
You will need to open a securities account with a fund sponsor or a brokerage firm to process the transaction(s) and hold the shares in your name.
Paper certificates of ownership are relics in today’s financial environment.
The proof ownership of a security is like money in a bank, an electronic record replacing caches of paper currency.
Choosing a Fund Sponsor or Stockbroker
In most cases, you can acquire shares directly from the sponsoring fund company by physically visiting one of the fund’s office or a representative or remotely transferring documents and funds across the Internet.
Most index funds can also be purchased through a local stockbroker by opening an account and depositing funds.
If you intend to buy funds from different fund sponsors, a brokerage firm may be the better choice because they will provide consolidate information in a single statement.
On the other hand, if you expect to acquire different index funds from the same sponsor (The S&P 500 index and the CSI 300) or acquire a single index fund, working with sponsor of the fund would be convenient.
Opening an account
Opening a financial account with a fund company or stockbroker is like opening a bank account or applying for a loan.
Be required to provide identification (Social Security number and driver’s license in the United States) and certain financial information such as your net worth and employment status.
Do not be offended by the questions you might be asked opening an account.
Financial firms in most countries are required by law to “know their customer.”
Deposit Cash
Depending on the securities laws in the country where the transaction occurs, buyers of index funds may be required to have cleared funds in their accounts before the transaction is executed.
In other cases. The buyer might have one to three days to deposit funds for payment.
Confirm the requirements for payment with the fund sponsor or brokerage firm before you enter an order.
Monitor Statement of Holding
After purchasing and paying for your fund shares, the fund sponsor or brokerage firm will send you an electronic or written confirmation of the transaction and the receipt of the shares into your account.
Thereafter, the firm – known as a “custodian” -will send monthly statements detailing your holding and any transactions that have affected the account since the previous statement.
Despite the extensive effort to maintain accurate records, mistakes occasionally happen. For that reason, review your statements as they are received to check for errors.
If you discover a mistake, contact the custodian immediately.
Final Thoughts
Initiating an index fund investment program is a great first step to financial freedom and psychological security, but it is not the only step on the journey.
Accumulating significant assets takes equal measures of
- Discipline. Diverting current income from the pleasures of today to saving for tomorrow is not easy. Nevertheless, it is essential if you want to reach your future objective.
- Knowledge. Expend the effort to understand different index funds and how they are likely to perform in changing economic environments to select the investments that will deliver the highest return with the lowest risk.
- Patience. While “good things come to those wait” is a popular advertising slogan, it is especially applicable to investing. The benefit of compounding interest accrues to those who can wait for the longest before invading the principal (spending any of the accumulated assets).
- Confidence. Being able to manage your risk tolerance effectively – understanding which investments are worthwhile and which to avoid – is required in a complex investment environment. Self-knowledge allows you to understand why some investments make you anxious and how to proceed to differentiate between perceived and real risk.