In the previous lesson, we explained what stock exchanges are and how they operate. In this class, we will predominantly talk about stock market indices.
Stock market indices are one of the most visually recognisable features of a stock exchange as they are often used on the news, in films or in TV shows.
Typically you would see a table of flashing prices that are swiftly moving from green to red. It can seem a bit confusing as to why prices on a screen are moving to rapidly.
The prices included in the table were not put there by chance though, more often than not they make up what is known as a stock market index.
A stock market index is essentially a group of companies that are all listed on the same stock market.
Stock market indices can be created based on a number of different characteristics. The most common characteristic is size, whereby an index will be produced that includes the largest companies on a particular stock market.
The most obvious example is the FTSE 100, which includes the 100 largest companies listed on the London Stock Exchange.
Arguably the most famous index fund is the S&P500, which includes the 500 largest companies in America, like Apple, Amazon and Google.
It is also common for stock market indices to be formed based on different sectors. You could get an index that is made up of only tech stocks or perhaps it could be made up of pharmaceutical stocks.
Stock market indices are formed so that investors can track the collective performance of a group of stocks.
Therefore an index fund that is made up of American technology stocks would give you some idea of how that sector is performing in the United States.
If you were to buy every stock in an index, it could get very expensive. Brokers in the UK usually charge around $10 for every transaction that involves a stock.
Therefore, if you were to buy every stock in the FTSE100, it would cost you $1000 in transaction fees alone.
To resolve this issue and to allow smaller investors to invest in a larger range of companies, the finance industry created something called an index fund.
An index fund is an investment fund that allows investors to buy every stock in a stock market index by putting their money into a pot with other investors.
An investment bank or wealth management company will manage the fund and will use the collective money to buy each stock.
When you invest in an index fund, a management fee of around 0.1% is charged annually – which is pretty good when most major indices increase by around 8-10% every year, on average.
In terms of investment, putting money into an index fund is considered standard advice for new investors wanting to expose themselves to stocks.
The reason for this is that index funds include a large number of stocks that operate in a variety of different sectors, which means that the diversification of the investment is high and that risk is reduced.
When it comes to what a stock market index represents, legendary investor, Warren Buffett, puts it in the best way.
He says: “when you invest in the S&P500, you are buying America”.
In a nutshell, a stock market index represents the economy of a country. In fact, stock market indices are known as ‘leading indicators’ for the economy, which means that they give some insight into how well the economy is going to do moving forward.
Index funds tend to be impacted the most by country-specific information as they represent the wider economy.
If you invest in an index fund that is made up of a specific sector, you are technically investing into that specific part of the economy. Obviously in the case of sector-specific index funds, sector-specific information is what drives the price of the index up and down.
There are a number of advantages when it comes to investing in an index fund. A key advantage would be that the funds are usually very cheap to invest in.
As I mentioned earlier, to invest in a single stock with a broker in the UK, it would cost you around $10 for the transaction fee.
The transaction fee for an index fund is considerably less at around $1.50 per transaction.
Another advantage is that you don’t have to do anything because an investment bank or wealth management company will be arranging the fund for you. This means that investors don’t need to worry about buying stock, selling stock or dealing with administrative tasks.
It’s important to point out that index funds don’t typically have a fund manager, which is a good thing as managed funds tend to have worse returns through human errors or increased transaction fees. For those reasons, not having having a fund manager is advantageous too.
Finally, index funds typically have strong and consistent returns that are often consider to be unachievable for individual investors.
Despite the wide praise for index funds and obvious advantages, it’s important to balance this lesson out with the potential disadvantages.
As mentioned, index funds do not have a manager, which should be considered as an advantage in most cases. However, if there is a talented fund manager that delivers returns that are greater than an index fund, investors will not benefit from the management of that manager.
Another disadvantage is that index funds are not overly flexible. This is problematic if things change significantly in the economy as investors are not able to manually change their positions in order to protect their money from stock market crashes.
With that said, it’s important to note that most investors are not adequately skilled to manage their own investments. Therefore, this point is not so applicable to the majority of investors.
For that reason, most investors are exposed to stock market volatility within an index fund, whether they like it or not.
When investing in an index fund though, it’s best to have a long term perspective. Thinking too short term will likely force you into making bad decisions like selling your investments when you shouldn’t.