What is index investing?

OK, perhaps one of the main reasons why most Canadians are still stuck in high fee mutual funds is because they don’t understand the concept of index investing, and how and why it is superior to the more active (and more expensive) style of investing. When speaking with investors I never assume they have extensive investment knowledge. In fact most have very limited knowledge, and that’s not a criticism, that’s just the way it is. Surprisingly, money and finances and investing is a very low interest category for Canadians. Canadians will spend an incredible amount of time and energy when it comes to their careers and making money, but when it comes to helping their money make money, they take a pass. But it can pay massive dividends to take even a modest amount of interest in your monies to make those monies work as hard as they can for you. It can be life changing. And you do not have to become a financial expert in any sense, you can simply develop an understanding of the basics.

This blog will at times get back to the basics and attempt to demystify the investment process to show you how easy it can be to understand investing, and to then move on to those simple and ‘better’ investments. During my years as an advisor educating Canadians on investing and lower fee index portfolios, it was my job to take the complicated and make it simple, make it easy to understand. I’ll pull from that experience and try to deliver that Easy Button for investing. And here’s the thing, it ain’t rocket surgery. The investment industry wants you to think that it’s all very complicated and that you’ll never figure things out. They like to throw out a lot of terms and jargon that they know you don’t know. They will speak in a different language. That way, you’ll always feel that you need them, and that you have to pay them the high fees. Mostly, you don’t need them, and you don’t have to fork over a significant part of your wealth over the decades. You can get this. If someone is being clear and honest with you, they can help you understand the investment basics with a 10 minute conversation. If you have a couple of minutes, read on.

We’ll start with the most common style of investing and that’s ‘active’ management. That means that there’s a manager and at times teams of folks trying to guess which companies to buy and sell. Now the word guess is perhaps not entirely fair, they do not guess, they do an incredible amount of work, and they spend an incredible amount of time evaluating companies. Those folks can make a lot of money, so you have to pay them a lot of money. You have to fork over a considerable amount of the returns generated by your portfolio.

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The problem with all of that expensive leg work is that it typically does not lead to better returns compared to simply buying a big basket of market leading companies. That’s index investing.

The most common type of index investment suggests holding a big basket of the most valuable and successful companies across all major sectors of the economy. That means holding the most valuable technology companies, the most valuable retailers, the most valuable banks and insurance companies, the most valuable health care companies and so on, and so on. A market index fund will simply hold the ‘biggest and the best’ companies in a country. You’ve likely heard the expression ‘blue chip’ companies – big and successful companies with the potential to continue on that successful and profitable path. So what kind of companies end up in a market index? Well for US technology leaders think of Apple, Google, Microsoft, Facebook, Amazon, Netflix, Texas Instruments, plus many more household names. In the retail space you’re going to own Walmart, Home Depot, Lowe’s, Costco, Target and on and on. More household names. The index fund is going to own those companies because those companies earned their way into the index by being successful. You’re not going to pay a manager 2% or more for the right to own those great companies, you’re going to pay perhaps .05% in an index fund. Do you want to pay 2.5% in annual fees to own Apple, Google and Microsoft. or do you want to pay .05%? Yes that should be a rhetorical question.

Here are a couple of simple analogies that help to demonstrate the difference between expensive active investing and passive index investing. The active managers are looking for the needle in the haystack. The market index fund simply buys the whole haystack. While active tries to beat the market the passive index fund simply buys the market. Let’s use a sports analogy.  The active manager will make a guess (bet with your money) as to which NHL team is going to win the Stanley Cup next year. The index fund is going to own the entire league. As an index investor you’re going to own the Stanley Cup champions, the semi finalists, the quarter finalists and yes the also rans – think Maple Leafs, sorry bout that my fellow Torontonians. Let’s not even think to move up the 401 to mention the Habs.

So why is index investing superior to active investing? Once again, it largely comes back to the fees. Even if an active manager demonstrates some talent, that talent can be quickly gobbled up by the high fees. If an active manager outperforms the market by 1% every year, but the fees are over 2%, well say goodbye to your market out performance.

Secondly, in the large cap (large company investment space) the actively managed funds and index funds will hold so many of the same companies. It will then truly come back to – do you want to pay 2.5% to own Apple, or do you want to pay .05% to own Apple and the other market leaders?

Once again, the question of what is the superior form of investing is not up for debate. The question would be …

Why are you still holding your high fee funds?

There are many simple solutions found on this site, from self directing your portfolio to lower fee managed portfolio solutions (nothing for you to do but sign up for lower fees while others take care of the index fund investments). It’s not complicated, and it’s not a difficult process to say goodbye to your high fee investments. In a manner of minutes you can do the paperwork or complete an online process that will help you cut your investment fees by 50-90% or more. Think of it this way; 30 minutes of your time might help you save tens to hundreds of thousands of dollars over the decades.

Now that’s time well spent.

Dale

Chief Disruptor @ Cut The Crap Investing

Questions? Send them to cuthecrapinvesting@gmail.com

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