This is a continuation of my previous post on Index investing:
If you have not read it yet, I encourage you to take a look—it provides a solid foundation for understanding how timing impacts index investing in the S&P 500.
In my previous post, I talked about investing in the S&P 500 index, but I realized I did not do a great job of explaining what indices are and why they deserve consideration.
Investing is a crucial step toward building long-term wealth, and capital markets have become a popular choice for those looking to grow their savings. The premise is straightforward: as companies grow, so does the value of your investments. However, picking individual stocks can be intimidating and requires extensive research and expertise. To simplify this process, many investors turn to index investing—a passive and efficient strategy that has gained significant traction.
But before diving into ‘how to do index investing’, it is essential to understand what an index is and why it can be a useful for your portfolio.
What is an Index?
An index is a group of companies combined together to track their overall performance. For example, the S&P 500 Index tracks the performance 500 largest publicly traded companies in the United States , while the NIFTY 50 tracks the top 50 companies listed on the National Stock Exchange in India.
To put it in simpler terms, lets build an index that tracks the ‘quality of the roads in your city’. Imagine you have 200 roads and rate each one out of 10 based on its condition. Summing up these ratings gives you an overall score that represents the city’s road quality. At the start of the year, this score might be 1380 out of a possible 2,000 (number of roads * maximum possible scoring of each road). If it improves to 1450 by the end of the year, it indicates that, on average, the city’s roads are in better condition, even if some individual roads have worsened.
Financial indices work in a similar way—they summarize the performance of a broad set of companies into a single number, making it easier to understand trends and track progress.
Who creates these financial indices?
Leading financial institutions like S&P Global, stock exchanges, and financial experts create these indices (sometimes called “index providers”). They are designed to provide a snapshot of how certain segments of the market are performing, helping investors and analysts track economic trends wihout thinking about the individual stocks in those sectors/segments of the economy/market.
Why should you invest in an index?
Much like the road example, an index represents the overall performance of a group of companies. If you believe that your country’s economy will grow, it is reasonable to assume that the top companies in that economy will also grow over time. By investing in an index that tracks the top companies in your country, you can tap into this growth without having to pick individual stocks. The logic is simple and powerful—invest in the collective progress of the economy or a particular sector of the economy.
See how simple it is? You are not trying to predict which individual company will succeed. Instead, you are leveraging the concept of an index to grow your wealth over the long term.
Which index should you invest in?
The world of indices can seem overwhelming at first. Here are some of the most popular indices by region:
- United States: S&P 500, NASDAQ 100, Dow Jones Industrial Average
- Canada: S&P/TSX 60 Index
- India: NIFTY 50, Sensex
- Europe: FTSE 100 (UK), DAX (Germany), CAC 40 (France)
- Asia: Nikkei 225 (Japan), Hang Seng Index (Hong Kong), SSE Composite Index (China)
Each of these indices represents a broad spectrum of companies and industries, making them ideal for passive investing. Do not go by this list, just do a simple google search and find out the major indices in your country.
How to invest in these indices?
To invest in an index, look for ETFs (Exchange-Traded Funds) that track the performance of these indices. Here is how you can do it:
- Use your stock trading app: Search for ETFs using the index name (e.g., “S&P 500 ETF”).
- Choose low-expense ratios: Select ETFs with the lowest administrative fees to maximize your returns.
- Focus on well-known indices: Famous indices like the S&P 500 or NASDAQ 100 are reliable choices due to their global recognition and historical performance. Avoid niche or speculative indices, such as those tracking highly volatile sectors like space exploration, unless you have a strong risk appetite.
Lump sum vs SIP: What works best?
Now that you understand what an index is, should you invest in one go (lump sum) or on a regular basis? This brings us to the concept of SIP (Systematic Investment Plan). A Systematic Investment Plan (SIP) is a method of investing a fixed amount of money at regular intervals—monthly, quarterly, or annually. When combined with index investing, SIP becomes a powerful tool for building wealth over time.
Why choose index investing through SIP?
- Eliminates individual stock risk: By investing in a group of companies, you mitigate the risk of poor performance by any single company.
- Avoids timing risk: Regular investments through SIP ensure that you buy at different market levels, reducing the impact of market volatility.
- Passive investment strategy: It requires minimal effort or active monitoring, making it ideal for busy professionals or those without a finance background.
Mutual Funds vs. ETFs: Which should you choose?
Many non-finance individuals tend to choose mutual funds instead of ETFs due to the ease of access. While mutual funds can be beneficial in certain scenarios, they often come with higher fees that eat into your returns. If your goal is passive investing in a broad index, ETFs are the better choice.
Always remember: the fund manager running the mutual fund needs to get their salary, and that salary will come from your investment. This is in contrast to ETFs, where no one is actively managing your money (they are just tracking an index via some automated processes), resulting in lower costs.
Leverage the power of AI and LLMs
For beginners, financial jargon can feel overwhelming. Here is how you can leverage Large Language Models (LLMs) like ChatGPT or Google Gemini to guide your investment journey. Use the following prompt in either Chat GPT or Google Gemini:
Sample Prompt for ChatGPT or Google Gemini: “My name is [Your Name], and I am [Your Age] years old. I have no prior knowledge of capital markets and am based in [Your Country]. I am interested in investing in a broad-based index to begin my investment journey. Could you please provide a list of the major indices available in my country and the corresponding ETFs that track them? I would also like guidance on how to buy these ETFs, especially if I plan to invest a fixed amount every month. Additionally, as you suggest the indices and ETFs, I would appreciate an explanation of the financial concepts involved, such as how ETFs work, what they track, and the advantages of passive investing, so I can better understand and make informed decisions.”
This personalized approach ensures you get region-specific advice while learning the basics of investing.
Index investing via ETFs, coupled with SIPs, is a straightforward and effective way to participate in the growth of capital markets. It eliminates the risks of timing the market or relying on individual stock performance. For beginners, the simplicity of this strategy, along with the availability of tools like Chat GPT and Google Gemini for guidance, makes it accessible and manageable.
So, start small, stay consistent, and enjoy the journey of wealth creation through the capital markets.
Disclaimer: https://vinaysachdeva.com/disclaimer/. The opinions expressed in the blog post are my own and do not reflect the view(s) of my employer. This content is for informational purposes only and should not be construed as financial advice. The author might have ownership in the companies/indices described in this blog post.