Warren Buffett is a famous guy. Even if you don’t know the specifics, you’ve probably heard of him and how he’s probably the most successful stock investor in the world.
Here’s a little-known fact: there’s one bit of investing advice he has repeated multiple times over the years.
“Most investors, both institutional and individual, will find that the best way to own common stocks is through an index fund that charges minimal fees. Those following this path are sure to beat the net results delivered by the great majority of investment professionals.”
-Warren Buffett in 1996
“A very low-cost index is going to beat a majority of the amateur-managed money or professionally-managed money.”
-Warren Buffett in 2007
Other very smart, very financially savvy people agree.
“Buy index funds. It might not seem like much action, but it’s the smartest thing to do.”
“Most of my investments are in equity index funds.”
– William Sharpe — a somewhat less famous guy who actually won the Nobel Prize in Economics. His academic papers, which are compulsory reading for finance majors worldwide, put me to sleep numerous times in business school.
What does this have to do with travel?
I don’t know about you, but when I travel somewhere, I like to be 100 percent there.
Investing in index funds is passive. You don’t have to know anything about finance; you don’t have to set up a brokerage account; you don’t have to check on your investment. In fact, index investing works best when you ignore your investment, so this is something you can do even if you travel full-time.
And even hardcore travelers should plan for the future. There will come a day when the body just won’t be able to do a work-to-stay exchange or get a random bar-tending job somewhere. This is where saving and investing come into play.
What exactly are index funds?
As far as investments go, index funds are probably the least glamorous. They’re a low-cost investment, so nobody would spend precious advertising dollars promoting them. And because there isn’t much to do when you invest in index funds, they don’t really make the news either.
I’ll try to explain this in as few words as I can. Feel free to skip this section, though, and get right to why index funds rock and how to invest in them.
An index is a grouping of many, many individual stocks. There are different indices, each of which is made up of a certain set of stocks.
The S&P 500 index, for example, follows the stock movements of 500 U.S. companies. You can use the S&P 500 to tell how well the market, as a whole, is doing. If the S&P 500 index drops, you can take it as a sign that the U.S. stock market isn’t doing very well.
An index fund replicates the movements of an index. You can invest in an S&P 500 index fund, for example, and the value of your investment will go up and down along with the stocks in the index.
What’s so great about index funds?
You don’t need much money to start
As I mention in the title, you can start with $100.
You get better results than many other investments
As Warren Buffett has repeated again and again over more than one decade, investing in an index fund could be the best thing you can do to grow your money.
Index investing usually produces better results than investing in actively managed funds — funds where professional Wall Street types pick and choose which stocks to invest in. A whopping 80 percent of these actively managed funds fail to perform as well as the index.
Whenever you invest in a fund, you have to pay the fund manager. Because an index fund just drifts along with the index, the manager doesn’t need to do much, so you don’t have to pay much in management fees.
You’d have to pay higher fees if you were to go with actively managed funds, which perform worse 80 percent of the time anyway. And if you were to pick and choose individual stocks yourself, not only will you pay high trading fees, but you also probably won’t do as well as the index.
How good is the return of an index fund?
It depends on which index fund you choose. It also depends on how well the market performs during the period of time you invest in the index fund.
Over the long term, the S&P 500 index historically has a 10 percent rate of return. This sounds great when you compare it to the 1- or 2-percent interest that term deposits (also known as CDs in the U.S. or GICs in Canada) offer.
But over the short term, an index fund could very well have negative return. This means that you may end up with less money than you put in.
The key with index fund investing is just to neglect it for a long, long time. This is why it’s best if you only invest the money you don’t plan to use for the next few years.
Even if the index performs poorly over the short term, odds are it will recover if you’d just give it time. The best thing you can do is not to panic and to just let your money stay there. This way, when the market recovers, you’ll enjoy the gains.
How to invest in an index fund
Just speak to your bank about setting up a mutual funds account. This is the easiest way to do it.
(There’s another way to invest in an index fund: through exchange-traded funds (ETFs) — but these work best if you have at least $30,000 to invest. Since we’re talking about starting small, mutual index funds seem like the better choice.)
With many banks, if you have access to online banking, you can set this up online. You can also go into a branch and someone there should be able to help you. (Be careful; they may also try to get you to put your money in other investment products. You pay lower fees with index funds and the bank doesn’t like that.)
If you don’t mind doing a bit of research, you can look up management fees at various banks and go with the lowest-fee fund. This fee is usually a percentage of the amount you invest. Here in Canada, TD Bank currently has the lowest-fee index mutual fund at 0.33 percent of the investment amount. American index funds often have even lower fees.
If you want to read up more on index funds, here are some great resources
Images: 1 & 4. 401(K) 2012 (CC BY-SA License); 2. StockMonkey.com (CC BY 2.0 License); 3. goodmami (CC BY-SA License); 5. Mark Hirschey (CC BY-SA 2.0 License); ; 6. Myfuture.com (CC BY-ND 2.0 License).