Should A Beginner Be Investing In Index Funds?Summary: A low effort way of achieving stock market exposure and returns is by investing in index funds. Should a beginner be doing this? There can be little doubt that one of the prime factors that puts people off investing in assets quoted on the stock exchange is the complexity. Unfortunately, this is not just the case for purchasing securities directly, but also for investing in funds (professionally known as collective investment funds, but more commonly referred to as mutual funds, unit trusts and investment trusts). The financial services industry has grown to such a size in most developed nations that there are literally hundreds of 'general' funds and many hundreds of other more specialised funds. The choice is bewildering even for professionals. To be frank, there are so many funds available that it is almost impossible for anyone to select the 'best' and there will be a strong case of buyers remorse as every investor will be able to find another fund that has performed better... Under these circumstances, all any private investor or financial adviser can reasonably hope to do is to select the most appropriate fund. This would mean that the investor would like to be in 'financials' or 'energy' or 'retail' and then adds in a couple of other guiding factors such as the amount of risk they feel willing to take. From there, it is often a case of crossing fingers and hoping for strong performance. As is often proved, the general public has a tendency to invest in the hottest funds at the very top of the market peaks and then sell out at the very lowest of lows. The 'tech bubble' in the years around 1999 to 2001 offer ample evidence of this. Therefore, what of the private investor that simply would like to put their money into the stock market and has no fixed or strong views about what sectors they like? For these investors, especially if they do not plan to actively follow the market, but instead wish to simply save into a fund and forget all about it (most people!), investing in index funds may be the ideal solution. The concept of an index fund is actually quite simple to grasp. The money of a large number of investors is pooled together, enabling the fund operator to buy and sell in larger volumes on their behalf. The fund operator will mimic the holdings as closely as possible of the index being tracked. Since each company has a different weighting, relative to market capitalisation, the fund needs to try and copy this. This means that the fund will hold much more - in percentage terms - of some companies than others. From here, the fund is hoping to replicate the performance of the index. As index funds are designed to have a low turnover and very little 'active' management, they are designed to be low cost. Many 'passive' funds like this do not even have a fund manager. Instead, most of the work is carried out automatically by computer. As described in this article the difference that is made by fees (when compounded) over a number of years can be quite substantial. It is not to be underestimated. Some funds replicate the market by using futures and options. The funds generally allow no borrowing which means that the futures should not add overly to the market risk being taken. While the management can be quite complex, it is quite logical, as this article about portfolio tilting helps to explain. It is difficult to argue that investing in index funds does offer a number of benefits to either the beginner investor that has yet to learn much about what is really going on and the lazy investor that simply wants to be 'in the market'. Please note, there is nothing wrong with being a lazy investor - as long as the individual recognises this and acts accordingly! There have been numerous studies that show that the majority of active funds do not manage to outperform the market consistently. Therefore, simply by taking 'the market' and cutting fees substantially, many investors find that they can receive quite market returns with very little hassle or expense. Beginner or not, that sound appealing! If you would like to read more about related topics, please follow these links:
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