What Are Index Funds?

Index funds are essentially collections of multiple companies, providing a way to buffer risk by diversifying your investments rather than putting all your money into a single company or cryptocurrency. Investing in individual companies is more akin to trading—like purchasing a home, renovating it, and attempting to sell it for a profit within weeks. This approach demands significant skill, market knowledge, and timing. Even seasoned investors face considerable risks, often relying on a good measure of luck.

To gain from index funds, the focus should be on "time in the market," which is often referred to as buying and holding. A vivid example of this strategy can be found in my Nana's experience. While sorting through documents in her attic, I discovered she bought her house for £3,500 in the 1950s. Fast forward 73 years, and despite no maintenance efforts and the house being in poor condition, its value has increased over 100-fold simply due to the passage of time.

When investing in an index fund today, barring a significant global event, you likely won't see much movement in just five weeks. However, like my Nana's investment in real estate, holding onto an index fund for 50 years could yield exponential growth.

Why Index Funds Are Considered a "Safer Bet"

Every investment involves a degree of risk, but with index funds, you are effectively betting on the performance of an entire economy—such as the S&P 500, which represents the U.S. economy—rather than a single company. You might wonder, "How can I be assured that the economy will grow?" or "What if the economy collapses and I lose everything?" These were precisely the concerns my wife raised when I contemplated investing.

For context, I'm drafting this article on my iPad during a flight to Poland. Just to highlight how rapidly things change, before 2010, the iPad didn’t exist, and Google Docs was unavailable until 2006. Even more astonishing, Google itself was founded in 1998. Imagine how something as revolutionary as Google has transformed the economy!

Investing in an index fund does put your capital at risk, similar to investing in individual stocks. Yet, the pivotal difference lies in the fact that with index funds, you place your trust in the broader economy instead of relying on the success of a single company. Historical performance doesn't guarantee future results, and the data presented here reflects the situation as of August 22, 2023, at 3:00 PM.

In the past 25 years, Apple, an American company, has grown to match the entire economic output of the U.K. Predicting which companies will thrive in 25 years can be challenging (just think of Blockbuster, Toys R Us, and Kodak). However, if I were to ask whether you believe the American economy will be in a better position 25 years from now, I am essentially asking if you think that America will continue to deliver superior goods and services compared to today.

Given that groundbreaking innovations like the iPad, Google Docs, and Google itself were non-existent 25 years ago, it’s understandable why I view investing in index funds as a risky yet relatively safe wager. My past missteps with EasyJet and cryptocurrency starkly contrast the "safe bet" nature of index funds, but I have no regrets about those losses. For insights on this, check out "Why Bad Decisions Are Still Better than Indecision."

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