Rather than picking individual ASX shares, many investors opt instead to invest in index funds.
Index funds don't offer the same market-beating potential as picking individual shares does. But even so, there are some significant advantages to using these investment vehicles that make them a superior choice for many investors.
For one, you don't need to dedicate nearly the same level of time and research to building an effective portfolio compared to picking individual shares. Beating the market with stock picks is a difficult endeavour. Even professional investors who dedicate their lives to beating the market often fail.
For another, index funds require almost no ongoing effort. You can simply buy the fund and put it in the proverbial bottom drawer. There's no need to read annual reports or concoct financial spreadsheets.
However, there is a right way and a wrong way to invest in index funds. Today, let's go over the right way to use these efficient investing vehicles and how anyone can use them to build real wealth.
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The secret to investing in ASX index funds
The superpower of an index fund is its ability to nurture winners and weed out losers over time. Every mainstream stock market index uses a weighting mechanism that is tied to market capitalisation (or a company's size). That includes Australia's S&P/ASX 200 Index (ASX: XJO) and the American S&P 500 Index (SP: .INX).
These indexes weigh every stock in their portfolios according to market cap. The largest stocks get the highest allocation in said index. That's why, on the ASX 200, Commonwealth Bank of Australia (ASX: CBA) currently makes up more than 10% of the entire index. Conversely, a relative minnow like Ampol Ltd (ASX: ALD) gets around 0.25%.
These indexes are rebalanced every three months or so to ensure this formula is adhered to. This means that, over time, the most successful companies get allocated more and more influence in the index (and thus in index funds). Meanwhile, the poor performers are suppressed and sometimes removed entirely.
This underscores the passive nature of holding an index fund. The hard work is done in the background, and the investor can just set and forget.
Don't take it from me, take it from Warren Buffett
So what's the secret of investing in these index funds to build wealth? Invest as often and as much as you can, and reinvest all of your dividends. Yes, index funds can be volatile. Yes, they can get hit hard during stock market crashes. But most, including both the ASX 200 and the S&P 500, tend to go up over time.
That's why a regular investing schedule that is agnostic of price and what the market is doing at any given moment works so effectively. Employing a rigorous dollar-cost averaging strategy with these index funds is going to serve any investment extremely well, in my view. This will depend on individual circumstances, of course. Some investors might be able to invest $2,000 every month. Others might only be able to manage $500 every quarter.
Obviously, the more you invest and the more frequently you do so will be the largest factors in determining how much wealth you can build. But the principle of sticking to your plan and investing regardless of what the markets or the economy are doing is the vital secret to building wealth. As Warren Buffett once said:
Consistently buy an S&P 500 low-cost index fund. I think it's the thing that makes the most sense practically all of the time.. Keep buying it through thick and thin, and especially through thin. The temptation when you see bad headlines in newspapers is to say, well, maybe I should skip a year or something. Just keep buying. American business is going to do fine over time, so you know the investment universe is going to do very well.
