Hopefully you haven’t lost the will to live and you’re super excited about the prospect of your spare cash working hard for you. In a previous post I explained what a stock and a bond was.
First things first, what’s an index? You may or may not have heard of the ‘FTSE 100’. This is an index that is based in the UK and it’s a group of the UK’s top 100 companies based on market capitalisation (no worries if you don’t know what this means, here’s a nice explanation: Market Capitalisation ).
A list of the companies in the FTSE 100 can be found here: FTSE 100
As the previous blog post explained. Investing in just one company is as risky as it gets when buying stocks (unless you can set aside a large proportion of your time researching the company and I’m talking about analysing annual reports, investigating the company’s industry and what economic and global factors could affect the company’s profits in the future) and for the majority of investors like you and me, being able to spread our hard earned cash over many companies is probably the best way to go.
This is where index trackers come in. Instead of buying 1 company’s stock, you have the option to buy all 100 companies in one go by purchasing a unit from a fund.
- Funds sell units (not stocks).
- Each unit is made up of the value of the group of stocks from the index that it’s tracking
- There are 2 varieties of units
- Income – These pay out distributions directly to you
- Accumulation – These use the dividends paid by the companies in the index to buy more stocks on your behalf
A more in depth look at the different between income and accumulation units can be found here: Income vs Accumulation
Here’s a quick run down of looking at a fund’s page: Vanguard FTSE 100 Index
- This tells us that this tracker follows the FTSE 100 index and it’s the unit type of income
- This is the cost of 1 unit (you don’t have to buy them in whole units). The ‘Change’ tells us the change in price from the previous day
- This is the number of stocks that unit price comprises of
- This is the Ongoing Charge Figure. More on fees later
- How risky the unit is out of 7. 1 being the least riskiest and 7 being the riskiest
Here’s an example of why buying a unit from an index tracker fund trumps buying an individual stock:
Investor A buys 10 shares in Company A.
Company A’s shares will fluctuate on a daily basis and in the worst case scenario the company may eventually go bankrupt, in which case investor A loses all of his cash.
Investor B buys 10 units in a FTSE 100 index tracker
The index tracker unit price is going to fluctuate on a daily basis, however unlike investor A, if a company in the FTSE 100 was to go bust, the unit price will drop but the investor is still invested in 99 other companies. The only way investor B would lose his money is if all the businesses in the FTSE 100 went bust.
Units do pay out distributions (much like stocks paying dividends). When these are depends on the fund but you should be able to see from a funds website, how often it distributes money to its unit holders.
As well as stocks, you can invest in bond funds too. Another example is Vanguard’s UK Government Bond Index Fund. This fund buys Government bonds of varying lengths of maturity.
Now you might be thinking. Great! I don’t have to put all my spare cash in one company, I can buy an index tracker unit and effectively buy into 100 different companies. Plus, if I don’t fancy too much risk with companies, I can buy a unit in a Government bonds index tracker because hey, when did the Government last go bust?
Fantastic, now your on board with index tracking, there is just one last bit I want to show you. There are many stock market indexes around the world. The S&P 500 (US), Nikkei 225 (Hong Kong) and FTSE All Share (London) are just a few.
Now what if there was a fund out there that followed all these different indexes, so not only was your spare cash invested in many companies but these companies were all over the globe. Well there are and one of the cheapest funds you can purchase is from Vanguard: Vanguard LifeStrategy 100% Equity
If you take a look at the portfolio data tab, you’ll see this is actually a fund of funds, which is giving you global diversification. Just think, when you’re sleeping, your cash is still working away.
They also do a whole bunch of other funds which are split between a globally diversified portfolio and Government/Corporate bonds, Vanguard calls these LifeStrategy funds.
I personally have chosen to buy the Vanguard LifeStrategy 80% Equity fund. This means that if you were to invest £100, £80 of that would be used to be stocks and £20 would be used to buy Government/Corporate bonds.
I’m hoping this hasn’t been too overwhelming. There will be future posts on fees (which is a hotly debated topic in the finance industry) and tax efficient wrappers (I’m talking about the beauty of ISAs and the SIPP, Self Invested Personal Pension)
If this has only left you wanting more then welcome to the club!
Just a practical note here. Please, please do further reading if this is the first blog you’ve come across on this subject. It’s by no means certain that you’re money will go up over time and that you won’t lose all that you invest. However, I’m of the opinion that unless global capitalism fails spectacularly, I think investing in index trackers is about as good a break as you’re going to get in investing.