Are you starting your investing journey? With so many options and all the noise around investing, it can get overwhelming trying to figure out what to do.
One relatively simple investing strategy popularized in recent years is index investing. It offers broad diversification, low fees and historically high returns.
If you’re interested in becoming an index investor, here’s how to invest in index funds to build long term wealth
What is index investing?
Index investing is a form of passive investing where investors attempt to replicate the returns of the market as a whole rather than paying someone to try and beat the market on a consistent basis.
There are many ways to do that, but the most effective one, from a cost and time perspective, is to buy and hold ETFs that closely follow indices that represent the market.
4 reasons why you should invest in index funds
Index investing has been growing in popularity since the 1970s, and for good reasons:
1. Index investing is a low-cost option
Passive investing, in general, is cheaper because by limiting the number of trades, you limit your trading fees.
With ETFs, it’s even cheaper because you can buy them commission-free at most discount brokerages.
Another benefit of ETFs is that they have low Management Expense Ratios (MER) compared to other investment vehicles such as mutual funds. In Canada, most mutual funds cost between 2% and 2.5% a year, while a typical ETF portfolio would cost less than 0.5%.
Passive investing is also tax efficient. When you actively manage your investments, you buy and sell often throughout your investing lifetime, and you owe taxes on the profits you make on each of your sales. When you manage your investments passively, you buy and hold assets for a long period of time. You’ll incur most of your capital gains taxes at the end of your investment lifetime (i.e. when you’re in a lower tax bracket).
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2. Index funds often outperform actively managed funds
A lot of research (like this report) found only a small percentage of active fund managers outperform index funds. These are professionally managed funds with resources and access to information, yet they still fail to beat the markets on a long term and consistent basis.
What does this mean for you, or any individual DIY investor?
Unless you’re extremely lucky, you probably won’t be able to consistently beat market returns either.
However, with an index investing strategy, over a long period of time, you can expect an average yearly return of about 7% before fees and tax. Remember, fees and taxes are kept at a minimum with index investing.
This 7% figure is an industry benchmark that comes from the historical average return of the S&P 500 since inception and adjusted for inflation. So it’s not out of your personal reach.
3. Index investing is a simple strategy to implement
Index investing requires minimal time and research compared to other strategies. You’ll still have to do some research to figure out what ETFs to buy and how to allocate each of them in your portfolio.
But fear not, you won’t have to study balance sheets and P/E ratios, or the perfect timing to enter and exit positions.
The amount of trading with passive strategy is also limited, so it shouldn’t take too much of your time to keep your investments in check.
The most difficult part of index investing might actually be not letting your emotions rule your behaviour and strong discipline. When there are market swings, stick with your long-term strategy. Remember, historically, the markets have always trended upwards.
4. Index investing offers easy broad diversification
Indices are a great way to limit unsystematic risk. Unsystematic risk is the risk associated with a particular company or industry. If you combine indices together to make a portfolio, then you can diversify most of your risk by choosing indices that represent various industries in various geographical markets.
How to start investing in index funds in Canada
First, build your portfolio with an allocation that works for you. Choose a combination of ETFs that represent indices that follow a large part of the markets. You can also choose your level of risk/expected return by combining stock ETFs and bond ETFs. Generally, stocks expose you to more risk but have better returns than bonds.
When comparing ETFs that track the same index, pay attention to:
- Tracking errors – the divergence between the price behaviour of your portfolio and its benchmark
- MER – Management Expense Ratio – how expensive the fund is for you
- Level of asset – how reliably their fair market value can be calculated
- Trading activity – monitor the buying and selling behaviour
Together, these four components will give you an idea of the ETF liquidity. ETF liquidity is the ease of which an asset can be turned into cash without affecting its market value.
Start index investing to build your long term wealth
Once you figure out what you want to invest in, open a brokerage account at an online discount brokerage and start building your portfolio.
Use your maximum contribution in registered accounts such as RRSP, TFSA and RESP before you start investing in non-registered accounts. You don’t pay taxes on profit and dividends in registered accounts, so that is a good way to make your investments more tax efficient.
To build long-term wealth, the most important thing you can do is contribute early and contribute regularly to benefit from compounding interests. For example, by contributing $5,000 a year (and reinvesting the interest) over 40 years, you could retire with over a million dollars.*
*Assuming a 7% return on investment (average S&P 500 return since inception, adjusted for inflation) and an average blended MER of 0.14% (Canadian Couch Potato portfolio).
The bottom line
Are you ready to start building wealth with index investing? Build an ETF portfolio that diversifies your market exposure, start investing at a discount brokerage, and contribute regularly to take advantage of compounding interest over time.
This article is a guest contribution from Brendan Lee Young of Passiv. Passiv is portfolio management software that makes DIY investing easier. It integrates with your brokerage account and you automate your portfolio management. With Passiv users can invest and rebalance their portfolios in one-click.