Introduction
In recent years, the topic of financial freedom is often intertwined with index funds. Whether it's the dedicated followers of the FIRE (Financial Independence, Retire Early) movement or investment legends like Warren Buffett, they all firmly believe that index funds are the best investment method for ordinary people in the stock market, and even an important tool to achieve financial freedom.
The Paradox of Index Fund Investment
When preparing this program, a rather contradictory phenomenon was discovered. In an ETF (Exchange-Traded Fund) list ranked by market capitalization, the top five are all index funds, indicating a large number of investors choosing this investment method. However, when ranking by trading volume, most of the top-ranked ETFs are still index funds. This is not a positive sign. It represents a significant contradiction and trap, suggesting that many who buy index funds may not truly know how to use them for investment. This could turn ordinary people who hope to achieve financial freedom through index funds into new victims of the stock market.
What is an Index Fund?
Understanding Stock Indices
To understand index funds, one must first know what a stock index is and its significance. In 1896, Charles Dow published the world's first stock index in the Wall Street Journal. He added up the prices of 12 stocks in the market and calculated an average to help investors intuitively see the overall performance of the stock market. This average is the so-called index.
However, Dow's index had two obvious problems. Firstly, it was a simple average, which was inaccurate as some companies with more stocks and larger market capitalizations had a disproportionate impact on the average. Secondly, it selected too few stocks, only 30 even today. This was somewhat representative in the past, but with thousands of stocks in the market now, 30 stocks are too limited to represent the entire market.
Later, index calculation methods adopted various weighted algorithms, and the number and types of stocks included in the index also changed significantly. There are indices that reflect the overall market, as well as those for different sectors or countries. The most well-known one today is probably the S&P 500 Index, which contains about 500 stocks and calculates a number through a certain weighting algorithm of stock prices. This number itself has no practical meaning, but its significance lies in comparing historical data to obtain market performance trends.
The Birth of Index Funds
The real meaning of these indices is not just about trends. Their deeper implications directly led to the birth of index funds. Looking at the 20-year line chart of the S&P 500 Index, on the surface, we can connect any two points in history to calculate the overall return rate of the stock market during that period. But in essence, this entire chart represents the overall return rate of all the stocks in the index over history.
The stock market is essentially a zero-sum game. Someone's profit is someone else's loss. But in the end, there is a collective "report card," which is the line chart formed by the index. This index can be regarded as the average return of all participants. Here, a crucial concept is introduced: when an individual or institution's investment performance is above this average, we say they have "beaten the market." It should be noted that beating the market does not necessarily mean making a profit; it just means performing better than the market average.
Over a long period, the index shows a growth trend, meaning it is profitable. However, the reality is that 90% of investors lose money, and 80% of funds eventually disappear. Only less than 3% of funds can beat the market in the long run. After deducting management fees and hidden taxes, it is almost impossible for fund investors to beat the market.
This is similar to a phenomenon in quantum physics. Just as we can know the overall probability of particle decay in a radioactive substance but cannot predict the specific decay time of a single particle, in the stock market, we know that there must be a few winning stocks, but it's difficult to predict which ones and when. This is called "regression to the mean" in statistics.
So, since a few successful stocks can make the entire index profitable over history, and assuming the index will continue to grow in the long-term future, instead of trying to pick those few winning stocks, why not buy all the stocks in the index and aim for the average return? This is the concept behind index funds. Index funds contain the same stocks as the index, and their performance is basically the same as the index they track, helping investors achieve the market's average return.
In 1975, John Bogle, the founder of Vanguard Group, established the first index fund in history, later renamed Vanguard 500 Index Fund, to track the S&P 500 Index. At that time, this idea was ridiculed as "John's Folly." But Vanguard's first index fund earned $17 million for investors in 5 years. In the following half-century, index funds have become the largest type of fund in terms of market capitalization, chosen not only by small investors but also as the main investment of national pension funds. The FIRE community also regards it as the most important investment product for ordinary people to achieve financial freedom.
Can Index Funds Really Achieve Financial Freedom?
The plan of the FIRE community is to reduce consumption, increase income and savings, and then maximize regular investment in index funds. If the index continues to grow at an average annual rate of about 8% as in the past, through the power of compound interest, wealth growth can be astonishing.
However, the key question is whether the index will continue to grow in the long-term future. We know that past performance cannot predict future returns. To answer this question, we need to return to the essence of the index and understand what truly determines market returns.
Theories of Stock Price Determination
There are many theories in the investment market, which can be basically divided into two main schools. The first is the "intrinsic value" school, which believes that stocks have an intrinsic value, and stock prices fluctuate around this value. A vivid metaphor is the "dog-walking theory." The dog represents the stock price, and the person walking the dog represents the stock value. The key is to study the value of the stock, that is, the "walking trace" of the person walking the dog, to judge the long-term price trend of the stock.
The intrinsic value of a stock is determined by its future earnings. For an index, its trend is anchored by the comprehensive expected future earnings of all the companies in the index, and ultimately by the future economic trend. If you believe that the economy of a market will grow in the long-term and the market rules are not artificially manipulated, then there is a corresponding probability of long-term profit by investing in index funds.
The second school is the "castle in the air" school, which believes that stocks do not have an intrinsic value. Stock prices are like castles in the air, determined solely by how much the next buyer is willing to pay. The stock market is just a game of musical chairs. This school focuses on short-term market psychology and trends to predict buying and selling opportunities. If you belong to this school, then index funds are not suitable for you.
Traps in Index Fund Investment
Trading Frequency Trap
Although index funds are a long-term buy-and-hold investment, the ETF form of index funds makes many people treat them like individual stocks and trade them at any time. ETFs are funds traded on the stock market, which are divided into many shares like stocks, making it convenient for small-scale regular investment but also easier for people to try to predict buying and selling opportunities, turning long-term investment into short-term speculation.
Over - Reliance Trap
Many people mistakenly believe that index funds can definitely ensure profit and achieve financial freedom, and use them as the only investment tool. Although we are confident that the economy will grow in the long-term, there is still a possibility of a long-term decline or low return rate of the index. Each era has its own financial freedom tools, and it's important to judge whether it's too late to invest in index funds.
Time Trap
The power of index funds lies in long-term investment and holding to enjoy compound interest. However, it is too slow and boring for most people to坚持. The consequence of not being able to坚持 long-term is that you will miss the few but crucial growth periods in the market, resulting in insufficient investment time and giving up before the compound interest takes effect.
My Index Investment Strategy
Diversified Investment
I don't think relying solely on index funds can help me achieve financial freedom. My target investment allocation is 25% of assets in index funds, 15% in individual company stocks, 50% in real estate, and 10% in cash and other investment methods. This can help avoid many of the traps mentioned above, make it easier to坚持 long-term, control emotions during market panics, and reduce the risk of economic recession.
Long-Term Regular Investment
I recommend regular investment (定投), such as buying $100 worth of index funds every week. The advantage of regular investment is that it can prevent you from chasing high prices when the market is booming and allow you to buy more funds at a lower price when the price drops, reducing the impact of market fluctuations on the overall return of your investment.
Using Tax-Free Accounts
I choose to use tax-free accounts to buy index funds. The first advantage is that the dividends obtained can be tax-free or tax-deferred. The second advantage is that the money in many tax-free accounts cannot be easily withdrawn, which can prevent impulsive selling and increase the probability of long-term holding.
Homework for Index Fund Investment
Asset Allocation and Rebalancing
Modern index investment strategies and theories are not just about buying a S&P 500 Index fund. You need to consider the asset allocation and rebalancing between bond index funds and stock index funds to minimize risks.
Index Selection Breadth
You need to consider whether to focus on the US market, your home market, or the global market. Determine if a S&P 500 Index is sufficient, and how to allocate if you are an international investor. Also, decide whether to use index funds listed in your local currency or those on the US stock market if you are not in the US.
Personal Investment Plan
Determine your specific investment plan, such as whether to invest regularly or make a one-time purchase, what proportion of assets to invest in index funds, when to sell index funds to adapt to changes in your lifestyle, and how to operate tax-free accounts in your country.
I recommend two books to help with this homework: "Millionaire Teacher: The Nine Rules of Wealth You Should Have Learned in School" and "The Little Book of Common Sense Investing" by John Bogle.
My Chosen Index Fund
I buy an asset-allocation index fund that contains stock indices, bond indices, and indices of the US market, Canadian market, and international market. This type of fund automatically rebalances regularly. In Canada, I started buying index funds in 2016, initially buying 4 index funds and rebalancing annually, and then switched to this automatic asset-allocation fund. In the US, Vanguard's Lifestrategy fund (a traditional fund, not an ETF) and BlackRock's AOA and AOR (ETFs) are similar products.
In conclusion, if you decide to invest in index funds, make sure to do your homework first. Index funds are not the only way to achieve financial freedom, but they should be an essential part of your investment portfolio.
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