After my first post about the Raiz Invest app and how I used it, I realised that many people reading this have probably not the same information that I have. Two years ago I knew nothing about investing into equities, securities or commonly known as stocks. I did not know what are index funds, what are ETF's and what does it mean to have an investment portfolio. That's why I want to give a little introduction I recently gave to my wife about what is the stock market, index funds and what a regular person like you and me actually need to know to start investing.
I won't touch topics like stock prices of a given company or their market capitalization, because for most common scenarios it is irrelevant. For long-term investing it is irrelevant. For most people who just don't want to think too much about their money, but still want it relatively securily invested, it is not relevant either. Instead I want to write about how the stock market works on a high level and how you should invest into equities when you DON'T really want to look at it every day of your life and worry.
What is a company's stock?
Like money a stock is a value associated with something on a piece of paper. In this case that something is a part of a company. And yes, it can be digital (like money) and in most cases it will be these days. How is determined how much that piece of a company is worth? Simple: Supply and demand. More about that later.
When a company first lists to the stock market it basically takes a huge chunk of its equity, separates it by X million and each of those million pieces represent a part of the company which you can buy for money: a stock. You become a part owner of that company after you purchased the stock, a so called shareholder. When a company lists on the stock market, the initial stock price is determined how well the company did so far and how they the company is valued before the listing. Again, after that it is mostly supply and demand.
Changes of stock prices
If a company is doing well, its stock price will do well, right? Not quite. In general this is true when viewing the long-term trajectory of a companies value on the stock market. In short-term the stock price can often be driven by supply and demand. You can see this every time bad news, in many cases political, hits the fan. Stock prices of seemingly not related companies to that news start falling. Why? Because when people hear bad news they start selling they assets, often big amounts. When that happens the supply increases and demand drops, meaning prices fall.
The opposite is true for good news. This often happens when a company which lists on the stock market releases their quarterly reports about how the company is doing. If a company did will, the stock price will often immediately reflect that.
This short-term fluctuations level out most of the time and if a company does well in general their stock price will slowly go up with it. For most investors the recommended strategy is therefore to buy and hold. But what if that particular companies stock you bought is doing bad? Enter index funds.
What is an index fund?
Oversimplified when you invest an equal amount into two companies instead of one, you basically are creating an index portfolio already. Let's assume you invest $100 in company A and $100 in company B. Now A is doing well and you stock price goes up and is worth $120 the next month. Company B is having a hard time and the stock price is worth $90 in the next month. In total your stock portfolio is worth $10 more ($120 + $90 - $200, which you originally invested). Now we could say we create an index from company A and B and instead of you investing directly in A and B you would simply invest into the index and the index fund would take care of distributing your investment to company A and B.
This is basically what an index fund is, but for hundreds or even thousands of companies at the same time. Putting your money into an index fund basically allows you to invest into the economy as a whole or even particular niches as a whole. The approach is generally more stable than investing into a business directly, since it levels out if a few companies in the index are not doing well, but most of them are.
What happens if a company in an index is seizing to exist? It will simply will drop off the index. You will have lost a tiny fraction of your overall value you invested. This has probably already happened by the time the company dropped off and their share price was already low before that.
What returns can I expect from an index fund?
It depends on the index fund. There are many different types of index funds and each of them has (historically) different returns and growth. If you invested into an index fund like the S&P 500, which tracks the 500 biggest companies on the US stock market, then the average annual return is considered to be about 8%.
Other index funds offer high yields, meaning they pay out more in dividends every year, but might not track as well when it comes to the market value of the fund. You can decide to invest into small/medium/large cap index funds, international shares index funds or ethically conscious index funds. All come with different outlooks and yields, so you should check about their historic performance before investing.
Let us also be clear that history does not dictate the present or future. You could literally invest today and loose 20% of your portfolios value tomorrow. That's why it is important to invest for the long-term and let compound interest do its work.
What is compound interest?
Compound interest is basically interest on interest. It an asset has an annual interest rate of 10% then its value will grow by 10% each year. That also means the interest you earned the each year will grow by that same 10%, which will result in so called compounding and make the asset growth explosive the longer you wait. The easiest to illustrate this is when you invest $100 the first year and have 10% annual growth you would have $110 in the second year, or +$10. The second year you would apply the 10% on the total of $110, so the following year you would have $121, or +$11. If the interest rate of 10% is stable you would have doubled your original $100 after around 7.3 years.
Of course in reality we do not see 10% interest rates consistently all the time. Stocks especially perform sometimes very well and have even interest rates above 10%, but they can also drop in value in a given year. Your should look into the different historical return rates of what you invest in and make your own decisions of what is a reasonable risk for you.
Should I invest all my money into index funds?
The short answer is: of course not! You should make sure you have enough money or income which can support your monthly expenses. From that you should build an emergency fund or cushion, which you can draw money from in case of (as the name says) an emergency. The rule of thumb is to have 3-6 months of monthly expenses in that fund. You can save than money into a savings account, but it should be something easily accessible if needed.
If you then don't have other commitments, like saving for a home (loan) or other bigger things you want to afford in the near term, then you probably could invest the rest. You can automate the process to invest a set amount every month. They say that you should only invest as much as you can tolerate to lose, though this is probably bad advice when investing for the long term. Just imagine your assets value would drops by 50%, but will grow back in 5 years and potentially double in 10 years. Would you panic and take the money out once you lost the value of half of what you invested? Where you willing to lose that amount in the first place? If you think short-term, the answer is probably no and yes, you would take the money out. In the long term your answer would be the opposite.
So keep the money you need now and the money you will need close and don't invest it into volatile assets like stock market funds. Plan ahead, do your calculations and then decide.
Is there a faster way to build wealth?
Of course there is. While index fund investing is fairly stable in the long run, it is also very slow. If you want explosive growth of your assets you will have to wait at least 20 years and even then there is a risk that the economy is down at the moment you want to withdraw the money. A general rule of thumb is using the 4% rule to determine how much money you would need in liquidable assets (like stocks, bonds, savings). The 4% rule basically states that your total asset value should be big enough to never outgrow your money, in that case it means it should 25 times of your annual living expenses (or your living expenses should not be more than 4% of your total asset value).
Back to the question at hand, if you want to build wealth faster you should create value and sell that value. In most cases that means creating a business which fills a need and has the potential of scale. Of course this means a lot of work initially, but the reward can be huge as well. We are not talking about 10% growth rates here, but 100%/200%/300% etc.. This is not for everyone though.
If you don't want to start a business or simply enjoy your job or whatever you are doing, then index fund investing is probably the best way to grow wealth in the long term and be able to retire without much worry. It is also fairly passive and pretty much anyone can do it as long they have good money habits.