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Part 4: The Massive Diversification Solution: Index Funds

We want to diversify our investments broadly: any individual company’s stock may go down for a variety of reasons – some of which are impossible to foresee – and cause us to lose money. Spreading our investments around different companies, different sectors of the economy, and different countries can provide protection from these risks and limit how much we can lose in our portfolio. It can also increase our odds that we will own the high-returning investments that drive average returns.

So how much diversification is enough? Going from owning 2 stocks to 20 gives you a lot of protection from ignorance, as you go from risking 50% of your portfolio on any single company to just 5%. Diversifying further to 200 holdings still brings the risk down, but not by as much as that first ten-fold increase in holdings. It turns out that while there is a diminishing return to diversification’s benefits, that benefit doesn’t quite go to zero – there’s still a benefit to diversifying as much as you can. That has to be balanced against the costs of diversifying: there are trading costs as well as the time and effort it takes to manage more parts in your portfolio.

There is a solution however: index funds can provide you with massive diversification in an easy-to-use, low-cost package.

What an Index Is

Before getting to what an index fund is, we should touch on what an “index” is.

Indexes were created to answer the question of how the average company’s stock performed. The first indexes were for newspapers to be able to have some consistent way of saying what “the market” did that day. The Dow Jones Industrial Average (which you may recognize as the “Dow” or “DJIA” in the corner of your 24-hour news network’s screen or your newpaper’s business section’s banner) was a simple average of the stock prices of 30 large companies, chosen to represent the American stock market. Since then numerous indexes have emerged to cover various markets (e.g., the S&P500 for large American companies, the TSX composite for Canadian ones), which are essentially slight variations on the idea of measuring the “average” stock or the market as a whole.

Most modern indexes are not simple averages of stock prices like the original Dow, but weighted according to a company’s size: after all $1 move in the massive Royal Bank’s stock should affect the market much more than a similar move in the price of the much smaller Roots apparel company.

Indexes are very useful ways to track the performance of investments, and as a yardstick for investors to compare themselves to (did your portfolio under-perform the index or beat it?).

Index Funds

While they’re useful benchmarks, indexes are theoretical constructs – just averages of the stocks you could actually buy. It would have been a lot of work to buy shares in all 500 or so companies in the S&P500 if you wanted to actually get the performance of the index. At least, that was the case until index funds were created.

Index funds are a kind of mutual fund with a simple goal of tracking a given index. Without the marketing or management costs of a typical mutual fund, their main selling feature is often low costs, combined with knowing what it is you’ll be investing in.

All the big banks’ mutual fund arms have a set of index funds available to investors, as do many other mutual fund companies in Canada, though they do vary on their costs and how easy they are to actually buy.

ETFs vs Mutual Funds

An evolution in the way mutual funds are sold was the creation of the exchange-traded fund (ETF), which have skyrocketed in popularity over the last decade or so. These are mutual funds that trade on a stock exchange just like stocks, which can make them a little trickier for the average investor to buy. However, trading over the exchange allows ETFs to have the lowest possible fees for investors, which is a big selling point for index investors.

While most mutual funds are still actively managed (i.e., not index-tracking funds), many of the most popular ETFs are index funds. It’s typically by researching index funds that people first hear of the term ETFs. Indeed, ETFs have practically become synonymous with index funds, however there are some important distinctions: not all ETFs are index funds, and not all index funds are ETFs.

There are actively managed ETFs, which may have higher fees just like actively managed mutual funds, as well as low-cost index fund ETFs. Most traditional mutual funds are higher-fee, actively managed ones, but index funds also come as traditional mutual funds, many with lower fees (though the absolute lowest fees will be found with ETF products).

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Index funds are an easy and inexpensive way to get massive diversification: they may hold hundreds or even thousands of different companies within them at a minimal cost. Index funds can be traditional mutual funds or exchange-traded funds (ETFs) that you buy and sell over the stock exchanges through your brokerage account.

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