How index investing works
Many investors today do not have the time to thoroughly analyze annual accounts and study profit prospects for the coming months and years. However, investment decisions are made on the basis of these matters. At the same time, it is important to diversify across different portfolios during the investment. This is essential to exclude specific risks.
Spread of investment funds
For example, if you invest your money in only 2 companies from the same sector, for example 2 supermarkets, and something happens in this market, there is a real chance that this will have a big impact on your money. In addition to spreading, low costs, transparency and good tradability are also wishes that investors have, brokers such as DEGIRO or LYNX offer other possibilities in this. However, it has also been shown that such investors do better than, for example, stock pickers or investment funds.
In order to invest in indexes, you obviously also need to understand how this works. First, you need to understand how index investing works and how it is composed. First, you need to set up a kind of collection of securities that can be considered for the index. Selection is often made on the basis of a number of predetermined criteria. As a result, collections can consist of, among other things, shares , bonds and real estate.
After this, an initial selection is made based on a number of criteria. However, a further subdivision can be made based on company size, country of establishment and sector in which the company operates. This selection is often very difficult for an inexperienced investor to make themselves. Fortunately, companies such as S&P and FTSE can be called upon, which already do such things for the investor. This relieves the investor of some of the burden in the entire process. The only thing you as an investor have to decide is whether the vision that these companies develop corresponds with the vision that you have in mind.
Investment fund rules
The basic rules for the composition of an index are arbitrary, which means that they are determined by choice. This can lead to differences in interpretation between different index providers. It is therefore important that, when selecting an index, you take this into account, among other things, the underlying values and the criteria on which such indices are composed.
However, it is also possible that an index provider assigns a company to a completely different sector. This often occurs when we are dealing with a maximum weighting per sector or when a company is completely absent from a certain index. So take such differences into account when choosing a suitable index provider.
Weighing
When the index provider has decided which companies will be included in the relevant index, the next phase can be moved on. In this phase of the operation of index investing, it will be decided what the weighting per share or bond should be. There are various weighting methods, each with its advantages and disadvantages and different company characteristics, ranging from company size, profit, dividend policy to emphasize.
The most common method of weighting is the market capitalization, also considered a very realistic form. This form represents the total value of the shares, calculated according to the stock market price at that moment. However, this means that the stock market value is never stable and can change over time. One of the most important factors to which the market capitalization is subject is the demand based on recent news reports about a certain company.
It is also possible to calculate the market capitalization of a company yourself, based on a number of outstanding shares. For example, let 1 million shares be outstanding, at a current stock price of €40. The total market capitalization of the company will then be €40,000,000. But what will happen if the price drops to €36 the next day? Only €36,000,000 will remain, which means a drop of €4,000,000. This example shows that price fluctuations can have a major impact on the stock market value.
In market capitalization, the largest firms also get the highest weighting. But there are also other methodologies:
- Equally weighted: each company in the index is given the same weight,
- Dividend: This weighting emphasizes companies with the highest dividend,
- Volatility : The least volatile (price-moving) securities and/or sectors are given the heaviest weighting.
Selecting an index
When you decide to start index investing , there is more to it than just buying an index. Now that you know how index investing works, you can ask yourself which market you want to enter. Ask yourself which index can yield you? And what return do you want it to yield? You also need to inform yourself well in advance about the operation and content of an index. When you have handled all of this correctly, the most difficult part is also behind you.
Once you have decided which index you want to use and have found the appropriate ETF , the rest will normally be self-explanatory. However, it is important that you continue to meet the criteria. The ETF provider will ensure that the composition of the ETF is in line with the index. It is also possible to be added or removed at very low costs. All of this is also arranged by the ETF provider.
Maintenance
Where the success of investing in shares or bonds depends on the maintenance thereof, this also applies to index investing. It is not the initial choice that will determine the success thereof, but the maintenance of this investment. Markets, objectives and other factors can change over time. It is therefore important that you can adjust your portfolio accordingly and evolve with these changes. If you do not do this, you will not achieve great success with your portfolio.
Compare brokers and start index investing
Are you excited about investing in indices after reading this article about how index investing works? Check out which brokers you can invest in indices with and find the broker that suits you best!