The Stock Market Will Make Me Rich, Right? Right?!
Everyone’s fantasized at one point in their life about hitting it big in the stock market. Perhaps investing a sizeable chunk of their savings into a hot new biotechnology company or the latest smartphone application, and then WHAM! The company quintuples its earnings and now you can live comfortably off of the dividends. One can dream, right?
So What’s an Index Fund, Anyway?
After you come crashing back down to reality, let me tell you about the wonders of index funds and how their magic can allow you to reap capital gains without being a Wall Street Financial Alchemist. An “index fund” is a fund of money, much like a mutual fund, that tracks the performance of a stock market index. Popular stock market indices include the Standard & Poor’s 500, the Dow-Jones Industrial Average, and the Wilshire 5000. An index is simply a collection of companies on a given stock exchange; the S&P500 is a collection of five hundred large capitalization stocks in the New York Stock Exchange (NYSE).
Now, why in the world would someone invest in a index? Well, stock market indices tend to increase in value over the long-term, generally by around 7%-9% annually (average). Compared to professional money managers that oversee mutual funds, their performance is often in the 4%-6% range, and often lower. Picking individual stocks is a risky and rather chance-based game. Their are methods of evaluating a stock’s intrinsic value based on financial statements (fundamental analysis), or patterns to analyze in stock charts (technical analysis), but these methods are not guaranteed to produce profits and require tedious hours of studying. Index funds allow the everyday investor to place their money in a diversified fund of their choice and reap the benefits of a growing economy (or a faltering economy should the companies tank).
“…but I Want to Day-Trade and Make Millions Overnight!”
Now, I’m not saying the picking individual stocks should be avoided at all costs. Index investing is a fairly conservative approach to equity investment; you’re not going to get rich overnight by investing in an index fund. There is money to be made (and lost) in both index fund investing and individual stock selecting, but the scale is in the investor’s favor via the indexing method. One reason for this is because index investing is low-cost for the investor; you’re not shelling out fees to a money manager to pick stocks for you, you’re also not buying individual shares and racking up huge commission fees from a broker. Indexing is truly a low-cost and efficient way to get your money in the stock market and allow compound interest to work for you.
Index First, Gamble Second
To paraphrase from Burton Malkiel’s classic book “A Random Walk Down Wall Street” (I highly recommend for new investors), picking individual stocks should not be avoided if it’s something you [the investor] enjoys. If you’ve been bitten by the gambling bug and cannot help yourself from purchasing a few shares from the latest tech company, don’t let this article shun you away. The majority of your funds should be indexed, but allocate a small portion of your capital as ‘play money’ that can be invested in individual stocks of your choice, based on fundamental or technical analysis. Who knows, maybe you’ll strike gold.