Last updated in November 2020
Index funds are a popular fund for people aiming for financial independence and early retirement (FIRE). But what are they and how do they work?
When thinking of investing, many people think of buying single stocks. They, in this case, correctly assume that investing is associated with high risk and shy away from investing money. And yet it does not have to be this way. Investing can be low-risk and profitable, even for ordinary people.
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Table of Contents
How to make use of the power of index funds
What are index funds?
An index fund is a type of exchange-traded fund (ETF). An ETF is a collection of securities (e.g. stocks) that can be bought and sold at the stock market (exchange). In essence, it is a basket of different stocks. Which specific stocks you can find in this basket depends on the index fund.
Index funds have their name because they follow an index. An index is the measurement of a stock market or a subset of it. One example you may have heard of is the Financial Times and Stock Exchange (FTSE). The FTSE 100 contains the 100 largest companies in the United Kingdom.
Almost every market has an index and there are subsets indexes within these. For example, you can find indexes for technology companies, or bond indexes which follow the bond market.
How do index funds work?
Index funds are passively managed and thus a source of passive income. This is the opposite of actively managed funds. With these funds, a fund manager actively picks stocks they think will perform well and manages the portfolio by buying and selling stocks.
Index funds do not have such a manager. Instead, they will contain set stocks depending on the index type. For example, the FTSE 100 will always contain the 100 largest UK companies.
How much do they return?
The profit you can make from index fund varies depending on the index. For a well-diversified index, the average return lies around 7%. However, this is based on historical data and may change in the future.
As an index fund is based on individual stocks, there is no guarantee that you will make anything If the companies of your index do not grow. There could be long streaks of no growth during economic recessions. However, over time, you are likely to make a profit.
Index funds compared to individual stocks
Because you have many stocks in an index fund, you are likely to make less money from them compared to individual stocks. But on the bright side, the risk of losing money is also much lower.
This is because rather than one stock, you own an average of many stocks. Some stocks within the index will lose value, others will gain value. With an individual stock, you either lose or gain money but you cannot have both at the same time.
The magic of index funds works because the economy as a whole grows over time. This means more stocks will grow than lose value. Note that this is measured over time, during a single year, the majority of stocks may lose value. This is why it is recommended to only invest in index funds if you do not need the money otherwise in the next five to ten years.
Because you will not know when you can withdraw your money again without losses, index funds are not suitable for short-term investors.
How to choose the right index fund
First of all, before you can buy an index fund, you need to find an investment platform. This is the place where you can deposit money and hold your stocks. There are several factors you should consider when choosing a provider:
- Investment fees
- Platform fees
- Trading costs
- Fund selection
- User friendliness
The fees you pay are an important factor because they can hugely influence the profit you can make from index trackers. They are often percentage based, thus big investors will pay more than those just starting out. Generally, it is recommended to choose a platform with fees of no more than 0.5%.
If you are only just starting out and want to test the waters, Freetrade is a good investment platform. You can get started with as little as £2 and even get your hands on a free mystery share valued up to £200 if you sign-up via my link.
Selecting a fund
When it comes down to selecting a fund, there are different factors as well that you should consider:
- How diversified the index fund is
- Company sizes (e.g. small cap)
- Location (e.g. developed countries)
- Asset type (e.g. bonds)
Before making a choice, it is important that you do your research. You should only buy once you are confident about your choice.
Why are index funds so popular in the FIRE community?
You may have noticed that many FIRE aspirants use index funds as their investment vehicle of choice. This is because index funds have a higher growth compared to letting your cash sit in the bank. But they are also less risky than individual stocks and you can expect 7% growth per year on average.
This means you have a 5% net growth after inflation (-2%) and should safely be able to withdraw 4%. You may have heard about the 4% rule already which is a core concept of FIRE.
How to make use of the power of index funds summary
Index funds are a basket of stocks that are traded at an exchange. Compared to buying individual stocks, index funds have a lower risk of losing money but also will likely be less profitable. Their continuous growth of on average 7% makes them a popular choice for FIRE aspirants.
However, despite their nature, you can still lose money when investing in index funds. It is important that you do your own research before starting to invest.
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