Many people invest as a way to build wealth and make money while they sleep. So you’ve decided you want to invest - how do you get started?
Warren Buffet, world famous investor and one of the richest people in the world, says investing is “the process of laying out money now, to receive more money in the future”.
He says that the most sensible thing to do is to invest in something called an index fund, and he won a million dollar bet in 2008 in favour of index funds beating actively managed hedge funds.
In Australia, a 2019 study found that index funds performed better than 81% of Australian fund managers over the past 5 years.1
What’s an index fund?
Index funds are funds that have been created to match a financial index, for example the ASX100.
Instead of choosing which companies to invest in, index funds will buy shares in companies in proportion to their market share. For example, if you invest in an index fund that tracks the S&P/ASX300, you will own a proportion of all 300 stocks that are listed in the Index. This means that you make money based on the collective outcome of all stocks and bonds pooled together.
Because an index fund is an investment that is designed to follow and invest in a particular index, it means that no one’s actually picking which stocks to buy.
This is called passive management, which means you simply ride the market, as opposed to actively trying to make an educated guess on a winning stock.
An analogy to explain in layman’s terms
To explain the difference between index funds and active funds - it’s a little bit like investing in AFL teams. You could pay ‘an expert’ to study the players and coaches, and bet on a team that would win the season. It’s a high risk bet, relatively speaking.
Instead of trying to beat the market, you could own it instead. With an index fund, you would own a portion of the entire AFL draft, and instead of betting on one team to outperform every other team, you are betting on the whole AFL sport doing well.
Not every team will win, but overall you could still make money from ticket sales, merch and sponsorships over the years.
There’s also a difference in price — and in this metaphor, the fee that you pay your ‘AFL expert’ means you get less. That's why index funds are considered a simple, low cost way to invest.
The active investing industry is built on the idea that you, the consumer, can consistently “beat the market.” In reality, that’s incredibly rare.
Notes: 1. S&P Dow Jones SPIVA 2019
