How index funds beat the bank every time

Interest rates may be on the rise, but a total rise of more than 3 per cent is hard to conceive, and in any event would be of little use to anyone who is trying to exist on bank interest.

From time to time I’ve suggested that index funds are a good alternative in the right circumstances.

But as one reader wrote “you say an index fund by definition cannot go broke, and should keep paying dividends irrespective of the normal volatility of the stock market. Could you please explain this in more detail and let me know if some index funds are more secure than others.” An index fund is an investment fund which invests in a category of assets, rather than trying to pick winners out of the whole range.

It’s a bit like having a bet on every horse in a race.

But because you are backing every horse your returns will tend to be lower than if you picked a long shot winner.

Two well-known index funds have the ASX codes of VAS and STW.

The former invests in the entire Australian share market, the latter invests only in the top 200 shares.

Given that the top 200 is over 95 per cent of the market, their returns tend to be fairly similar.

Currently these two shares are paying about 4.5 per cent yield of which about 80 per cent is franked.

Of course, there are many other index funds such as those that track the S&P 500, the Dow Jones Industrial Average, and various specific asset classes such as bonds and gold. I tend to focus on index funds like VAS and STW because they track the Australian share market, and also pay franked dividends.

However, in consultation with your adviser you should decide which asset classes are right for you and the best way to invest in them.

The benefits of index funds are that they are low-cost, there are no specific shares to select, and you have immediate liquidity if the index fund is listed.

As far as security goes, the index cannot go broke because it is simply tracking a basket of assets.

But it will perform in line with those assets.

Therefore, if you chose an index fund that invested purely in crypto currencies, you would expect it to be more volatile than one which invested only in Australian shares.

Anybody investing in shares should take a long-term view and be prepared to hold their portfolio when the market goes through a normal volatile phase.

Furthermore, if they are retired, they should keep at least 3 to 5 years planned expenditure in cash form so they are never forced to liquidate shares at the worst possible time.

To get an idea of how the index performs, just have a play with the Stock Market Calculator on my website www.noelwhittaker.com.au

Here you can enter a notional sum, pick a startingfinishing date of your choosing and see how the investment would have performed if it matched the All Ordinaries Accumulation Index. For example, an investment of $100,000 in January 2010 would now be worth $281,000.

That’s a gain of 8.99 per cent per annum for 12 years.

I reckon that’s a better bet than bank interest.