Thing I Learned Today: Index Funds

by Brian Shourd on October 29, 2012

Tags: life

When I was in 4th or 5th grade or so, I remember one project in particular that we had about learning to do life stuff. Everyone in the class got to look through job ads, and pick their “job” out from whatever was listed. Then we had to use our fake salaries to pay for rent on houses we found in the paper, utilities, and buy groceries. We could use the rest to buy fun stuff in catalogs (I liked the Sharper Image at the time), and we were supposed to use a portion to invest in the stock market. We were given a cursory introduction - I honestly don’t remember much about it - and essentially we all picked random stock in companies that we liked and watched our investments like hawks. The whole project took weeks, and it is one of my only memories from grade school - that’s how good this project was.

Anyway, I remember that my idea was that since I didn’t know which stocks would play out, I would just buy all of them. Then some of them would have to pan out. At least, that’s how I remember it happening. I suppose it’s maybe not outside the realm of possibiliy that perhaps there is a chance that I’m remembering through rose-colored glasses.

Because it turns out to be a really good idea. A fund that invests in every company (or a representative sample thereof) is called an index fund. I learned about them in a book I read called The New Coffeehouse Investor, which I thoroughly enjoyed. In it, Bill Schultheis basically says that an index fund is the only sensible long-term investment and advocates doing nothing but investing in index funds and bonds, with a ratio depending on the amount of risk you are willing (and able) to take on. I liked it.

Let’s see how this idea of investing in everything at once works - and also the downsides. We’ll model choosing a stock with choosing a six-sided die from a bag of 100. Then roll the die and subtract 2 to find out how the stock performs.

If you have 100 dollars and put all of it into one stock, you have a 1 in 3 chance of losing money, a 1 in 3 chance of a modest return (100-200 dollars), and a 1 in 3 chance of a terrific return (>200 dollars).

However, if you invest 100 dollars into 100 stocks, and you roll 100 dice, your odds shift dramatically. You now have a 99.62 percent chance of a return between 100 and 200 dollars. Basically a sure thing. There’s only a 0.2 percent chance of losing money in this bet.

But, and it’s a big but, there is only a 0.2 percent chance of a stellar return either.

Now throw in the complication that in real stocks, it’s not totally random at all. People can - or at least they believe they can - predict which stocks will do well and which ones won’t. There is a real chance of winning big - but only if you take the risk.

Anyway, that’s what I learned today.