The benefits of investing in Index Funds

The demise of Debenhams is a stark illustration of the pitfalls of investing in a single company’s stock. Investing is good but it has to be done in a way which avoids high fees, minimises taking unnecessary risks or simply making non sensible choices. Index funds offer wide diversification and low fees which make them an excellent choice for most investors.

Pitfalls of investing in a single stock

Sometimes people can get emotionally attached to a particular company for one reason or the other. It is also common to hear some regret that they did not invest in a hot stock like Amazon, Facebook or Microsoft a gazillion years ago when its stock was still only worth a millionth of its present value. Everyone seems to have a story of an old colleague who made such an investment and is now rolling big.

However, there are thousands of such potential companies but you do not know or have the capacity to pick the right one unless if you possess a working crystal ball. To me, this kind of activity is akin to gambling on the horses. Debenhams, the British multinational retailer, was once a household name, particularly known for its huge department stores housing a wide array of goods and services. Any mom and pop investor would have chosen or advised others to invest in such a company. However the demise of this kind of business has been a long time coming.

Let us have a look at how the company’s share price has performed.

Debenhams share price

It is clear that any long term investors in this company would have been burned badly. Even worse if you owned a lot of stock and also worked for the company which is never an advisable thing to do.

The Indexer’s perspective

Now let us see how the stock has fared against the benchmark UK Index, the FTSE 100.

The differences are clear on this visual. Due to its composition of a wide array of companies in diverse sectors the index has steadily risen to outperform Debenhams and it certainly did not go anywhere near zero of the original value. When reinvestment of the FTSE dividend of nearly 5% is considered, returns would be way bigger than shown on the graph. Simply buying and holding while regularly topping up is the best strategy.

An index fund simply aims to track and closely match the actual index. It does not try to beat the market therefore costs are kept to a bare minimum compared to active funds which try to be fancy. Costs matter and along with maintaining a high savings rate are a major factor in determining portfolio gains over the long term.

To me this is compelling evidence that the sure way to building wealth is to regularly invest into a globally diversified portfolio of low cost index funds using methods outlined in this book. Progress will seem slow initially but the snowball will soon take shape and propel you to greater heights.

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