“The best time to plant a tree was 20 years ago, the second best time is now”
The quotation above could not be more apt for wealth accumulation. If you are going to be financially independent you should be building yourself a big fortune. To build a big fortune, time is one of your most important assest. In this post, I will explain to you what index funds are and why it’s so important to start early with index fund savings if you want to build a solid, fat FI-wealthbag. There are millions of people who swear to the index funds, and after reading this post, I hope you want to do the same thing!
What is index funds?
An index fund is a passive equity fund that aims to reflect both the equity composition and the return on the benchmark it follows. An index is therefore a combination of many individual stocks and is a measure of the value of all these shares within a market (eg World Markets Index, Europain Index, Nordic Index or Emerging Markets Index).
Let’s use the world index (MSCI World) as an example. If you have invested in an index fund that follows the world index, and this index rises by 7%, your index fund also rises 7%.
The World Index (MSCI World) consists of 1644 of the largest companies in the developed world (about 60% of the companies are in the United States). That is, if you invest in an index fund that follows the world index, the fund’s return will eventually depend on how the stock prices to these 1644 companies develops. For example, the world index (NSCI World) at the time of writing is composed of:
- Apple (2,39 %)
- Microsoft ( 1.80 %)
- Amazon (1.66 %)
- Facebook (1,14 %)
- JPMorgan Chase & Co (0,92%)
The things that determines how many % of each company the MSCI World Index (or any other index) consists of is the companies market value. Each company’s market value is constantly changing, so the fund is rebalanced twice a year. In 1 year there will have been changes in the composition of the (todays) 1644 companies. It is unlikely that Apple, Microsoft, Amazon, etc. will disappear from the list within a year, but among the medium sized companies there may be exchanges. And this is good (and self-cleansing) because it ensures that it always will be those companies who “want it the most” that will be a part of the index. This again ensures that the market in the long run will always point upwards, something I will come back to further down in this post.
Why is it really so “genius” with index funds?
Index funds are brilliant because you do not need 1) time, 2) knowledge or 3) interest to invest in it. Most people link the stock market with something that is stressful and time consuming, and something you should be careful about. For example I have lots of friends sitting and following the stock prices daily. They’re reading up and down on the stock forums to find their next purchase or to “reassure themselves” that the purchase / sale they did was correct by receiving support from others forum members.
Index funds are brilliant because it has low costs, typically 0.2 – 0.3 % (or even lower) management costs annually. The opposition to a (passive) index fund is the actively managed fund. An actively managed fund is a mutual fund managed by a team of managers. This team itself determines the composition of shares in the fund and when to buy / sell stocks. Each actively managed fund has its own team that analyzes and assesses the companies carefully and always tries to find the stocks that will be the next Amazon, Facebook or Apple. This simply means that the manager in an active fund tries to identify good companies and does not buy shares based on their participation in an index. Now, you’re probably thinking: “What’s the point of investing in an index fund when investing in an active managed fund means that someone with skills is doing the job?”. But is it really a smart move to invest in actively managed funds?
- Actively managed funds have high management costs, typically 1.5 – 2% annually. If your portfolio consists of actively managed funds, it means that 1,500 – 2,000 USD per 100,000 USD will disappear right in front of you. This will finance the managers salary. If you had placed this money in an index fund instead, you would only pay 200 – 300 USD annually. You might think that this difference isn’t significant? Well, take a look at the graph below.
Figure 1: Start capital of NOK 1 million. Expected 7% annual return and
management costs of 0.3% for index funds and 2% for actively managed funds.
Figure 1 shows how a fund portfolio of NOK 1 million develops with 7% annual return. The difference between the two portfolioss is the management costs of the funds. Each year, the index fund rises by 6.7% (7 – 0.3), while the actively managed fund increases by 5% (7 – 2). For many people, this difference may seem small or insignificant, but as seen from the figure above, in the long run there will be big differences. Figure 2 illustrates the difference in numbers.
Figure 2: The difference between index funds and actively managed funds at 7% return. The right column shows how much more you would have after x years if you only invested in index funds
Figure 2 shows that the difference increases exponentially. The reason for this is different management costs and the magic power that lies in interest rates. In this example, I have not even assumed a monthly savings plan. If I’d included monthly savings, the difference would be even more visible.
Imagine using the same example as before, but this time we add 10,000 NOK monthly savings in addition to the startup portfolio of 1 million NOK (120.000 USD). The result will then look like figure 3 if all other factors are kept constant:
Figure 3: Start capital of NOK 1 million and NOK 10,000 monthly saving. Expecting 7% annual return
and management costs of respectively. 0.3% for index funds and 2% for actively managed funds.
After 30 years, you will have saved 18.45 million NOK in index funds, while active funded funds would only have summed up NOK 12.7 million, a difference of NOK 5.76 million! And this is only because of management costs. See figure 4 below for more details for the different years.
Figure 4: The difference between index funds and actively managed funds at an expected
7% return and 10,000 NOK monthly savings.
2. Another solid argument for running away from actively managed funds is that they do not beat the index in the long run!
During the last 15 years (2002 – 2017) only about 6.5% of fund managers in the United States beat the index (see Figure 5). 6.5%! Have you invested in an actively managed fund and managed to beat the index over such a long period of time? Well, then I’m impressed! Because when the pros don’t make it, what is the probability that the average man/woman will do it??
Figure 5: SPIVA U.S. Scorecard – A report that measures the relationship between
actively managed funds and their index S & P 500).
You probably know some friends who invests in actively managed funds, braging about extremely high returns. Ask them next time what their return is through the last 5 or 10 years. I think it will be pretty quiet 😉
3. The compound effect is awesome. It means you get interest on what you invest, but also interest on top of your interest. Okay, this was though, so let’s take an example right away. Let’s use the example we used above. You have NOK 1 million, which gives you 7% return on an annual expected return, as well as you invest NOK 10,000 per month (NOK 120,000 a year). If we put this in the formula below we get:
- For example after 1 year: 1.000.000 + (120.000 x 1,07)^1 = 1.128.400 NOK
- After 5 years: 1.000.000 + (120.000 x 1,07)^5 = 2.092.640 NOK
- After 10 years: 1.000.000 + (120.000 x 1,07)^10 = 3.625.125 NOK
- After 30 years: 1.000.000 + (120.000 x 1,07)^30 = 18.947.549 NOK
Formula: FV = (TV + i) + r/100)^n
FV = Future Value
TV = Todays value
i = yearly deposit
r = interest per year (%)
n = number of years
As you can see the compound effect works like magic, an the effect is higher when the interest rate is higher. Zach from Four Pillar Freedom has a great article about compound effect here.
The market always goes up
Now that you know more about why you should invest in index funds, it’s time to think for some minutes about how many % it is realistic that you can expect every year in the stock market. If you track the MSCI World Index then you should expect an annual return in the area of 7 – 10 %.
But what if the stock markets crash? I’ve heard about it before! One of my friends lost 50 % of his stock portfolio during 2008 / 2009. When the market hit rock bottom he was forced to sell. But market crashes and corrections are a part of a stocks nature. It happened before, and it will for sure happen again.
But let me tell you something. The stock market will always go up. Not every month of course, and not every year either. But in the long run you will be the winner (as long as you don’t try to time the market). Actually the blogger “Engaging Data” created a game where you cant try to time the market here. Try it for yourself. I made it only 1/10 times. Will you do it better than me?
As long as you’re invested in index funds no matter what markets conditions, you will se the market go up. Why?
- There is no need to worry about temporary swings because the value of stocks have always increased as the earnings of the underlying companies have gone up. The index is self-cleansing. This means that the good performing companies will still be a part of the index, while the bad performers will be thrown out of the index. This again ensures that the market in the long run will always point upwards. The market is not stagnant. Companies routinely fade away and are replaced with new blood
- As I mentioned in bulletpoint nr. 1; the market is self cleansing. That means that when a stock loses 100 % of it’s value, it dissappears from the index never to be heard of again (and is replaced by another stock). But what about the upside? A stock can grow several thousand %. So in the long run this means that only the good, solid quality companies will be left in the index. And what happens to quality companies? They grow! And quality companies that grows also means that your index funds will grow.
Figure 6: History of U.S Bull & Bear Markets since 1926
Look at figure 6 above. It’s really powerful! The point with this figure is to illustrate that the market always will recover. Maybe there will be a market crash, but so what? Stay the course, folks! Look at the figure! What happened after the market crash in 2008 when the market tanked 50 % ? An enormous bull market started! And the bull is still riding today. Annually the S & P 500 has raised 17.9 % annually after 2008. And if you lost 50 % during the 2008 crash, you would have much more money now if you just stayed in the market. So keep on investing in index funds, and you will soon see that your net worth rise again to new hights! If your’e interested in more facts about why the stock markets always goes up, you can check out jlcollinsnh’s article here.
Which index funds do you track? Do you have other assets than index funds?
Until next time…Ciao!