Index funds are a really cool thing. They are funds where you invest your money into a group of assets (usually company shares) instead of individual shares. Index funds are also known as passive funds – because these funds tend to be mostly automated. Money in an index fund is invested based on the fund’s profile and the movements of individual stocks within the fund.
How do index funds work?
Let’s take an example:
Jimmy invests $1,000 in the NZ Top 50 index fund. This index fund tracks the performance of the top 50 highest performing company stocks in New Zealand. That $1,000 is then proportionally invested between the top 50 stocks. So 50% could be invested in the top 10 stocks, 40% in the top 11 to 30 and the remaining 10% in the remaining 20 stocks. All of this is automated and the actual proportions invested depends on the algorithm used.
An index fund reduces the risk associated with investing in an individual stock. However, the potential returns on index funds are lower than that on a high-growth stock because lower risk = lower return. However, when investing in an index fund, you are, in effect investing in the market. Historically speaking, stock markets tend to experience positive growth over a long period of time. Here are some examples:
This is the S&P 500 – an index which tracks the performance of 500 of the largest companies in the USA. It has had a steady level of growth from the 1990s till today. There were some dips along the way, but if an investor invested money in the S&P 500 in 2011they would end up with more money than they invested today in 2021.
How risky are index funds?
An index fund is NOT a low risk investment. But they are less risky than buying individual stocks. They are also waaaaay less risky than crypto. They do still come with a measure of risk attached. If we zoomed in the S&P 500 data, we can see some peaks and troughs. If you bought at a peak, you may lose your investment when it drops. It can take some time before you recover your investment:
In the example above, let’s say we bought into the S&P index at Jan 2020, just before the pandemic hit. We would have lost a lot of our investment value when it plummeted in March-April 2020. The S&P wouldn’t recover to its previous level until near the start of 2021. The key lesson here is that index funds can be volatile BUT over a period of time, you will be able to recover your investments. However, if you need your cash to be secure over a short-term (1 to 2 years) index funds may be too volatile for you.
Who should use index funds?
Generally speaking, if you have a good 10 to 30 years to go before retirement, index funds are a great place to stash cash. In fact, you can set a certain amount to drip feed from your bank into an index fund of your choice. Index funds can be broadly categorised into:
- High growth, High Risk
- Medium growth, Medium Risk
- Low growth, Low Risk
Since there are a wide variety of index funds, you can choose one that best aligns with your financial goals. Index funds are good for the average investor who doesn’t have much time to research individual stocks. They are easy to understand, provide stable long-term returns and are based on assets that can be valued. FYI, there ARE crypto indexes if you’re feeling lucky.
If you are based in NZ, smartshares has a good selection of Index Funds and Exchange Traded Funds (ETFs) to get you started.
If you like the idea of getting rich slowly, then index funds are probably good for you!