Why Index Investing
I’ve not written any posts about personal finance in a while because I assume most of you guys are here for MRCP “fun” but if I’m wrong let me know and I’ll start writing more on FIRE (financial independence, retire early). If you’re just starting your career I would urge you to concentrate on earning career capital first, to maintain your sanity because FIRE isn’t a quick and easy journey. For most of us it’ll take between one and two decades of full time work to achieve.
If you’re interested, career capital is currency akin to your ability to command freedom. For example a new graduate, regardless of whether they’re a new foundation doctor or someone with an accountancy degree, has no career capital at all. If they wanted “work-life” balance and planned to go part-time, perhaps 60%, they would be ignored if not laughed at. Fast forward to someone who is an established accountant or professional with a decade of active experience behind them and when you request something like this, you won’t be ignored. The only caveat is that the experience has to be active, in the sense you’re actively pursuing improvement. Simple ageing doesn’t necessarily equate to useful experience because we all age. This great book goes into some more detail.
If you were to take over a McDonalds franchise, what would be your first step? You wouldn’t fork out £100,000 to learn on the job unless you were a really bored billionaire and even then there are a million more fun things to do than own a McDonald’s branch. Talking to other franchisees would be helpful but nothing beats actually working as the lowest ranked crew member. Rotate from the counter to flipping burgers to washing the toilets before spending some time as the assistant manager and shop boss before taking the role of the shop owner. There is no shortcut.
Earn your career capital before you think about FIRE.
If you’ve busied yourself with earning career capital over the last few years, work life gradually becomes easier as you gain more independence and experience. It’s never my intention to give investing advice because my job is a medical doctor, and if you wanted advice on how to fix cars you wouldn’t ask a lawyer. This post is only a summary of my thought process of choosing index investing.
Instead of investing in great individual companies like Coca-cola, I choose to buy shares in lots of companies. This diversification is very useful, if not mandatory to spread risk. Although Coca-cola is unlikely to bust in our lifetimes the very recent collapses of Tesco and Toys-R-us should make us very wary of placing all of our eggs in one or even a few baskets. It’s popularly thought that you can attain proper diversification if you invest in at least 30 companies from different sectors/sizes.
An index is a group of companies on that particular stock exchange e.g. the FTSE 100 is the 100 biggest companies in the UK, and the S&P 500 contains the 500 largest companies in the US. When you invest £1,000 into an index we need to remember that our funds aren’t spread equally across 100 or 500 companies in the above examples. Instead they are divided by their respective sizes and market value. A simple example is if we imagine an index containing two of the biggest UK companies – Royal Dutch Shell and HSBC. Say RDS makes up 60% of our imaginary index and HSBC 40%, if we invest £1,000 we would effectively be investing £600 into RDS and £400 into HSBC.
By investing our capital into the FTSE 100 and letting the market decide how much money is allocated to each constituent company, we’re taking all our irrational emotion out of this decision. Otherwise why would someone invest £900 into Apple and only £100 into McDonalds? As investors, the fewer decisions we have to make mean the fewer wrong decisions we’re making.
UK markets have historically trend upwards about 7% annually pre-inflation but again you’ll appreciate that this is not guaranteed. For example one year it could drop 20% or more and then the next year could see a 30% gain. If you can stomach this volatility then you could stand to make a lot of money over the medium-long term. Remember that volatility is not equivalent to risk.
Why limit yourself to the UK FTSE 100 when there’s a FTSE 250 and a FTSE All Share?
You could argue that limiting yourself to UK itself is an irrational move because the biggest companies in the world are actually in the United States. If you only invest in the FTSE All Share, which is all the UK companies, then you’re missing out great companies like Colgate-Palmolive, Apple and Johnson & Johnson to name a few.
And then why would you only invest in the UK and the US when there are great companies all around Europe and Japan?
The other main advantage of index investing done correctly is the low cost. Instead of paying a fund manager 1 – 2% in annual charges for doing a worse job than index funds, we’re talking about annual costs of 0.25% or even lower depending on your fund/platform. You’ll appreciate than 2% costs compounded over 30 years is a lot of money, not to mention most fund managers underperform index funds so why pay someone to do a worse job.
So there you have it – low costs; better performance compared to most active funds; and great diversification are three very strong reasons why index investing is my first choice.
If you’re interested in pursuing FIRE and enjoyed this post, don’t forget to drop me a line below and I’ll respond to every one. I learnt everything I know about personal finance by reading this book, this book, this book and this one. You can get one of these books in FREE audiobook format using this link. Simply sign up to a 30-day free trial and if you don’t enjoy the service you can cancel any time free of charge at the click of button, and still keep your book.
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