This is a follow-up to my “Smart financial tips” series. I strongly recommend to start there and come back here. Anyways,
- Earlier we looked at what does “Stocks” exactly mean.
- Then, I explained how “Index funds” are built using these basic building blocks of “Stocks”.
- Finally, I argued that “Index funds” investing strategy is one of the best for an average investor like you and me.
This theory is well and good. But it’s not very helpful, unless we actually start actually using them in practice. In this post, I outline the steps that will help you to get started. Shopping for index funds is very much similar to your weekend grocery shopping in a supermarket. There are three simple steps. Namely :
- First, you need to determine WHERE to start buying?
- Then, once your drive down to the shop, you also need to determine WHAT exactly you will buy?
- Finally, you also need to determine HOW much of that (and probably also HOW often you will buy)?
Buckle up. We are going shopping!
Sidenote : Some section is divided into two :
- Mandatory : This section is a must-read. The information presented here is universal and applies to everyone irrespective of where you live.
- Optional : You can skip this section if you want. This is always minimized at the end by default, click to enlarge it. I have included information here that is specific for geographical locations.
1 : Where to buy?
You have made up your mind. You have the money. You are ready to go shop some index funds. But where do you exactly buy them from?
As I said earlier, this is very similar to supermarket shopping. If you wanna buy some apples, you wouldn’t directly go the farmer who is growing them, will you? Rather you would usually go to supermarket, which usually aggregates those apples (and lots of other such similar groceries). The supermarket sells those apples for a slightly higher price than what it bought from the farmer.
Similarly to buy index funds (or stocks, bonds among others) you would usually go to a “BROKERAGE”1. The BROKERAGE aggregates all these investment options and sell it to you. In turn, you pay them a little commission fee every-time you buy from them. These brokerages could be your regular banks (offering brokerage service in addition to your regular bank services), or exclusive marketplaces set out for this purpose (online or otherwise).
Some might be wondering why not directly buy stocks, bypass brokerage and thus saving commission fee. Like the apple example earlier, its theoretically possible to buy directly from a farmer but practically difficult.
Which Brokerage to exactly choose? (Click here)
Which Brokerage to exactly choose?
Europe/Germany? (Click here)
There are multiple ways you could open a regular brokerage:
- Via Regular Banks
Most of the regular banks should offer you an option to open brokerage with it. For example, I use the MaxBlue brokerage (no affiliation! with them) from Deutsche Bank (DB). For me, opening this brokerage was as simple as doing some clicks in my online banking account. Two days later, after some confirmation, an additional “depot” account appeared in addition to my regular account in my online banking page. Then, I was able to start buying stocks from them. From what I know, the process is pretty much similar in other banks. Ask around. I simply choose MaxBlue because I had account already with DB and I just wanted to get started ASAP.
- Online services exclusively setup for brokerages
Recently, these seem to crop up a log. These are apps in your phone or online web services. You can open online accounts exclusively for the purpose of buying stocks.
- Filtering criteria:
One thing that you want to look out for when choosing a brokerage is to see if they waive commissions off if you invest regularly. For example, I know MaxBlue (Deutsche Bank), ComStage (CommerzBank), and other such german banks offer an option called as savings plan (spar-plan). Basically, in a savings plan you say that you are going to invest regularly (say once a month) a fixed amount of money. Since the brokerages know you are going to stick around, they will waive off all the commission fee. This is especially very important if you are going to invest small amounts of money regularly. Otherwise, commissions will eat up your investment. But, apart from that for the index investing strategy it really does not matter. Just research around what works in your country and choose a low-cost brokerage.
Rest of the world? (Click here)
Rest of the world
- Max out the tax-sheltered options :
Tax-sheltered options roughly means that, the amount that you put in here and the profits that you gain from here is not taxed. Government exempts and kinda encourages you to invest in stocks up-until certain amount. Some examples would be ROTH IRA, 401K plans in USA. Not technically brokerages, but still your money should go always go into such systems. The money gone to tax is just gone. Check in your country what kind of options is offered. Often the best person to check is your HR manager.
- Regular brokerage:
Whatever money is left now you invest that via regular brokerages. Check the “Filtering criteria” that I wrote in Europe, to see how to go about it.
2 : What to buy?
The answer is simple, as you might have already guessed it : Index funds.
The brokerages, like a supermarket, will have plenty of options for you to choose from : both good (healthy) and bad (unhealthy) options. Like unhealthy food, there would be maddeningly dizzying array of tempting bad options for you to choose from. These bad investment options would be so well marketed and sugar-coated, it is easy overlook what is beneath it and fall for it. Also like food fads, every other year seemingly new breakthrough investment products will crop up and will tempt you. But then again, we all know how fads end. Please don’t give in.
Some examples of bad investment options are : actively managed mutual funds (P.L.E.A.S.E! avoid them), day-trading, “insert-any-fancy-word”-fancy-investment strategy marketed by brokerages, among others. Explaining why these are so unhealthy is beyond the scope of this current post, but I will try to explain them in upcoming posts.
When you go shopping, strictly restrict yourself to healthy-index-funds section in the brokerage-supermarket. Don’t give into the temptation and buy those greasy junks from the unhealthy sections. Your financial health will be in much better shape and will thank you later.
Now you have decided on the “Index funds”. But we learned earlier that there could not be not one, but multiple “Index funds” products. How do we decide which products of index funds to exactly buy? The answer is ……
For a body to function correctly, one needs a balanced diet : One that has mix of all the essential nutrients. Similarly, to keep your financial health in shape you need a mix of index funds. In investing, this balancing mix up is known as “diversification”. Diversification (holding a mixture of index funds) greatly helps you to balance out the risk/reward spectrum. 3
Now, within diversification the way you split your money around these index funds (or in general any investment option) is called “portfolio allocation”.
A good investment strategy is one that has a portfolio of well diversified index funds.
An example of such portfolio would be :
- MSCI World Index fund – This invests into 1600 companies across 23 Developed countries. Or in other words track developed market.
- MSCI Emerging market fund – This invests roughly into 1100 companies across 24 Developing countries. Or in other words track developing markets.
Such a portfolio already exposes you to the most of the market and gives you damn good diversification. In fact such a strategy is so good, that it will help (!gasp!) you beat most of the money fund managers out there (>95%). If you are interested in the hard numbers/proof, read this.
In fact, the great Warren Buffet (the third richest man in the world) himself believed in this strategy. He believed it so much that he held out a public bet. A bet that invited the active mutual fund/ hedge fund managers to beat the index funds.
“I publicly offered to wager $500,000 [in 2005] that no investment pro could select a set of at least five hedge funds – wildly-popular and high-fee investing vehicles – that would, over an extended period, match the performance of an unmanaged S&P-500 index fund charging only token fees. I suggested a ten-year bet and named a low-cost Vanguard S&P fund as my contender.”
Of course, Mr. Buffet wins at the end like he always does.
KISS : Keep it simple silly
One final note before we conclude this section. You could always develop complex diversified portfolio with many constituents. But, in my personal opinion (strictly personal, I don’t have numbers to back this up), the payoff with increasing complexity decreases. It’s very easy to maintain a simple portfolio : makes analysis easier, simplifies rebalancing, simplifies tax-preparation, among others. But to me the most important, a simple portfolio is easier to stick to. I personally started with a 4 index fund, switched to 3 index fund and then finally have settled down to a 2 index fund portfolio:
- MSCI WORLD – 70%
- MSCI EM – 30%
Jack Bogle, who or more less started this Index Investing revolution, says this
“Simplicity is the master key to financial success. — We ignore the real diamonds of simplicity, seeking instead the illusory rhinestones of complexity.”
My personal suggestion is to start with a simple portfolio and stick with it for the rest of your life.
What portfolio allocation to choose? (Click here)
What portfolio allocation to choose?
- For EUROPE and Rest of the World :
Andrew Hallam, whose book actually helped get started in this journey, maintains in his website index fund portfolio for all the different countries (bless the man!). Check that out here. You can directly use the portfolio listed there or tweak it to your personal needs.
- For EUROPE specifically :
When I started out I found the following two subreddit groups incredibly helpful.
Many who are on the path to FI post their portfolios and experience in those groups. I found this valuable. Also, when you have question, regarding portfolios or otherwise, you can post them there and the community is very helpful. Check them out.
3 : How to buy?
By now we have figured out the logistics. We know where to buy and what to buy. Here, I lay-down the steps for how (much, often) to buy them.
- Prerequisite : Save up enough for a rainy day. Calculate your monthly expense. And save at-least 4x-6x of your monthly expense and have the money before starting this process. This will come in handy during emergencies.
Steps to follow :
- Step 1 : Save aggressively and invest aggressively
Be frugal and save some money. Then split the saved money according to your portfolio allocation and then invest them IMMEDIATELY with your brokerage. In the following example, I show my simple two fund index portfolio. But, the process would remain whatever portfolio you choose.
You can automate this entire process with your brokerage, so you wouldn’t have to do anything. You can tell your brokerage
- to invest a fixed set of money (ideally whatever you save),
- in the portfolio of your choice (ideally index funds), and
- with the periodicity of your choice (ideally pay-check period – for most of us this is monthly)
I strongly recommend doing this automation for three reasons :
- Like I mentioned earlier, when you set up such an automation the brokerage will waive off the commission fee every time you buy from them. Because they know that you will be sticking them for sometime. In Europe/ Germany : such automation are called savings/spar plan. Commission fees can eat up your investment, especially if you are investing a small amount.
- The automation will take off your manual work and save a lot of time. Your pay-check will appear in your bank account. Then every month a fixed amount will magically disappear and will be buying off some index funds for you.
- Third, and probably most important, it will make you disciplined and stick to the plan. Sometimes with money its easy to get emotionally carried away. Sometimes you start thinking – “Hey the markets are up now, let me chunk the money together and invest them back when the markets go down”. You cannot time the market. It’s far better to regularly invest than predicting what is going to happen. Automation takes emotion out of your investment decisions. Technically, this strategy is called as “dollar-cost-averaging” and you can read why this is good here.
2. Step 2 : Periodically rebalance
In Step-1 you periodically invest in the portfolio of your choice. Although, you invest the money according to your portfolio allocation, due to the inherent market movements your portfolio ratio will change. You need to manually rebalance once in a while to keep your portfolio in check. In simple words, this means selling off the ones that have accrued more value than they are supposed to and buying more of the one that is lagging. An annual rebalancing of your portfolio will suffice. I will later better summarise the benefits of rebalancing. But for now, the curious readers can already read the benefits here.
- Where to buy?
- Pick a right brokerage preferably one that waives off commission if you regularly invest.
- What to buy?
- Pick a well diversified index fund portfolio allocation and stick with it.
- KISS : Keep it simple silly.
- How to buy?
- Do not time the market. Periodically invest every month.
- Rebalance portfolio every year.
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Until the next time, Ciao!