Investing Basics: Index Investing for the DIY Investor

Why low cost, passive index investing could be the ideal solution for the time poor DIY investor – by Christian Leeming

Those new to savings and investment could be excused for being more than a little daunted by the vast range of asset classes and investment vehicles that are available, and however carefully worded the marketing collateral is these days, issuers of  financial products all want to convince you that theirs is worthy of a place in your investment portfolio.

DIY Investor aims to debunk the jargon that remains in the industry and equip its readers to objectively appraise the suitability of different investment types for their individual circumstances. By setting long term financial objectives it is possible for the self directed investor to construct a portfolio of passive investments with exposure to risk that is in line with their own risk tolerance.

There are indices that deliver exposure to most types of investment both home and abroad and each comes with differing volatility and risk profile.

Those looking for a readymade diversified range of investments but without the costs that accompany actively managed collective investments may find index investing an attractive option; and here are five reasons why:

1)   Index Investing is Simple

Even for those with little investment experience, index investing is easy to understand.

The basic principle is that by buying a product that tracks a particular index – either via an index tracker fund or an Exchange Traded Fund (ETF) – you are automatically creating a portfolio of investments that are as diverse as the companies that make up the index.

Once you select the indices you wish to track, it is usually simple to set up regular contributions via your stockbroker and because the constituents of the index change over time there should be little need to rebalance your portfolio as it is effectively done for you.

Then, sit back and relax – markets will rise and markets will fall but you’re in for the long haul and you’re not looking to time markets or unearth the next ten bagger.

2)   Index Investing Works

Studies have shown that after costs and taxes index investors can consistently beat the performance of the average active investor and that over time index funds routinely beat the performance of actively managed funds.

A key factor in this performance is their very low cost; with the total cost of ownership of actively managed funds very much to the fore post-RDR.

As an example, FTSE 100-tracking Legal and General UK 100 Index, charges just 0.10% and several brokers actually offer a discount to this.

To illustrate the effect that fees can have the following examples represent £10,000 invested, achieving 6% annual growth over ten years:

• An actively managed fund charging 1.5% will grow to £16,929
• A passive tracker charging 25 bps will return £19,185

Those that practice index investing are not looking for instant gratification, they are seeking long term returns with diversified risk – they’re betting on the tortoise and, at least according to Aesop, could just be backing a winner.

3)   Index Investing can be Cheap

Low cost index trackers can be bought from your online broker and most offer ultra low commissions on regular investments. By pooling investments on a certain date many brokers will allow you to invest sums as little as £50 per month and build your portfolio slowly over time.

This is a good first step toward becoming a DIY investor – and by saving on commission and avoiding the cost of advice your portfolio will grow all the more quickly.

4)   Index Investing for the Time Poor

With masses of information and fundamental financial data to paw over, stock picking can take up an enormous amount of time; those flourishing the hazelnut may argue that its discovery justifies the amount of squirrel ordure under their nails, but index investors are able to achieve solid long term investment performance without living and breathing their portfolio.

5)   Index Investing for the DIY Investor

The government’s Retail Distribution Review (DIYs passim) changed the investment landscape for ever for many.

‘all things considered, here at the Fool we believe that an index tracker is the most suitable initial investment vehicle for the vast majority of people’

As they realized that the previously ‘free’ advice they received from their adviser was nothing of the sort some concluded that the performance of their portfolio did not justify paying for fee based advice and turned to DIY investing; their number was swelled by those deemed not to be sufficiently lucrative and therefore ‘orphaned’ by their adviser.

As an entry point to DIY investing, investment community The Motley Fool concluded, ‘all things considered, here at the Fool we believe that an index tracker is the most suitable initial investment vehicle for the vast majority of people’.

Those considering constructing an investment strategy around index trackers would do well to understand the risks they are exposed to and dilute this to a level they are comfortable with.

It is advisable to work out how much you will need to invest in order to achieve your financial goals and create a number of alternative scenarios by factoring in variables such as the effect of inflation.

Finally, keep a watching eye on costs – even small increases to dealing commissions or platform fees can make a big difference to the long term return on your investments – then be confident and Do it Yourself.