Imagine if you always had the top 50 Billboard songs on your iPod. How about always having the top 10 basketball players on your fantasy team? Or would you rather have the top 10 apps on your iPhone always at your fingertips? If all of this sounds good to you, then what do you think about owning the top 250 biggest Canadian companies in your investment portfolio?
Diversifying your investment portfolio is the best way to limit your exposure to risk, so why wouldn’t owning the top 250 companies be a great idea? You may be thinking … how do you own so many companies when you have limited funds to invest with. Well the answer is quite simple. Take advantage of index funds. Index funds were designed to follow the performance of the stock market indexes such as the S&P or TSX . This means that index funds invest in the top companies that represent the stock market index as a whole.
So what is so great about index funds? What happens when the market crashes?
An index fund essentially holds the top companies for the respective index that they follow. Whether it be the top 250 Canadian stocks for the TSX, or the top 500 stocks for the S&P, you’ll always be buying into the top companies that make up the index. For example, let’s say you own the top 250 Canadian companies on the TSX. If for instance, one of the companies goes bankrupt and disappears, what happens? Once a company drops out of the top 250, the fund automatically sells that company and buys the next company that enters the top 250. It’s akin to Justin Bieber’s song dropping out of the Billboard Top 50, with Rhianna’s new song replacing it and subsequently having the song automatically download to your iPod. Isn’t that great?
Undoubtedly, during bad times when the market goes down, the index fund will go down as well because it is tracking the stock market. So is there a fear that all your money will be lost?Remember that you own the top 250 largest companies in the stock market. What is the likelihood that all 250 of the biggest companies that make up the index go bankrupt at the same time? That’s the only way your entire equity will get wiped out to zero. Imagine what would happen to the country that belonged to that stock market if that happened. It will be chaos. Millions of people would riot. It’d literally become the end of the world if no one could afford anything due to the loss of jobs. I don’t think that’s a scenario that would be allowed to happen, despite all contrarians to the belief. Look at Europe, last I checked BMW and Mercedes were still doing just fine even with mobs of people being unemployed.
The beautiful thing about holding an index is the ability to take advantage of growth from all the companies that you own. Not only will this limit your risk in investing in the stock market, but it also reduces volatility. Let’s look at the chart for the TSX for the last 20 years:
Wouldn’t you rather invest in something like the index above than having to deal with the volatility of holding a single company like BlackBerry (formerly Research in Motion):
Charts courtesy of Yahoo Finance
The likelihood of experiencing instant astronomical gains by holding an index fund is unlikely to happen as opposed to holding an individual stock, but you are investing for the long term and not gambling your money for instant gratification. An index fund is also not a sexy investment to own. Who do you know that goes around bragging about the 7% they made this month holding the S&P 500 index? You’ll most likely hear your friends bragging about buying Netflix and getting a 40% gain on a jump in their earnings. What your friends won’t tell you is that they also bought Apple lost 30% since the beginning of the year. If you buy an index fund you very well might own both Apple and Netflix. You’ll experience both the gains and losses of both the companies, but don’t forget, with an index fund you still have another 498 companies working for you.
Is the index fund for you? Certainly it’s worth a look especially if you are a novice investor and don’t know too much about equities. The index fund will earn what the entire stock market returns. There’s no need to research individual stocks, no need to look for the Lebron James of mutual fund managers, just pick a stock market you want to follow and buy it. If you want to find good examples of how to build a balanced and diversified investment portfolio using index funds, head over to the Canadian Couch Potato site. There you’ll find mutual funds that are not only commission free to buy, but also have low management costs. Remember that even when buying mutual funds, make sure your fees are low to maximize you potential return.