Rising inflation and the war in Ukraine have contributed to stock market volatility. They have also raised the question of a potential market crash that thankfully hasn’t materialised so far. When facing such volatility, instead of panic selling, I like to take a more stoic approach and learn from my and other people’s mistakes. And what better time to do that than over the last few months? Let’s take a look at what index funds are and the four reasons why I kept investing in index funds during the recent market sell-offs.
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What are index funds?
An index fund is a type of exchange-traded fund (ETF) or mutual fund that is designed to mimic the composition and performance of a market index (for example, the FTSE100). For this reason, index funds are also referred to as passive funds. So if the benchmark that the fund mimics goes up in value, so will the fund.
On the other hand, we also have funds that are actively managed by portfolio managers. Their job is to choose what securities will make up the fund’s portfolio and their only goal is to try to outperform the market. If the fund manager makes poor investment decisions, this will cause the fund to underperform the market, which will essentially result in losses for the investors.
So, with that in mind, let’s take a look at four reasons why I continued investing in index funds despite volatility in the market.
1. Low costs
One of the reasons I continuously invest in index funds is their low expense ratio. To put it simply, this is how much a fund charges for administrative expenses, including maintenance, reflected as a percentage of the fund’s average net assets. Meaning, that if the fund I invest in has an expense ratio of 0.10%, I will pay a £1 fee for every £1,000 I invest. And the best thing is that this is automatically deducted from my returns, so I don’t have to think about it too much.
2. Tax-efficiency
In the UK, every time you make a profit from selling a security for a higher price, you are obliged to pay Capital Gains Tax. Because of the way funds are set up (to mimic a benchmark), they don’t really make a lot of trades. This means they don’t generate a lot of capital gains. In case a fund sells an underlying stock for a profit, it is required to pass the earnings to its shareholders as distribution at least once per year.
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3. Benefits of regular investment
Investing in volatile markets is quite a stressful and tricky task, especially if you try to time the market. Instead, I’ve worked out an amount that I’m comfortable with and I invest it every week in a range of index funds. Adopting a long-term approach has really helped me to stay put during the more chaotic weeks. In theory, by pound-cost averaging over a long period, I should be able to ride out any future market volatility as long as I keep on investing in index funds.
4. Diversification
Creating a balanced portfolio is a challenging task. However, recent events have again proven that a diversified portfolio can shield an investor’s wealth. Investing in index funds is basically owning a piece of many companies in different industries. So in practice, you are already diversified by buying into several index funds.
Personally, I’ve spread 90% of my investments in index funds and I keep 10% for stock picking and riskier ventures. In this way, I have wide exposure to different asset classes and securities.
If you want to invest but you’re not sure where to start, check out our investing basics.
Please note that this article is for information purposes only and is not intended to recommend particular investment strategies.
