Index funds or FX trading?
We all have heard it now and then. “Mike quadrupled his money by investing in Apple!”, or “Jenny from accounting made a killing shorting the EURUSD pair”. But is this really the norm? How could an average Joe pick out winning trades all the time, while preserving his capital? The answer is they obviously can’t. Good news however, there are ways to invest in the stock market while at the same time eliminating all of the unsystematic risk. With a bit of discipline and good money management it is even possible to consistently profit from trading Forex.
1.Dawn of Mutual Funds
The urge to be part of this great machine called the US economy was there ever since wall-street has been invented. Not so long ago, however it was an expensive process to buy even a single stock, unless one had access to a massive amount of capital. Mutual funds were the first step into the direction of making investing more attractive to the general public, since a large pool of money could trade much more cost effectively. Once a pool has been created it had to have a purpose: usually it was to generate a return, no matter what, hence most of them were “actively managed” or “total return” type of funds.
The theory sounds great, but the many different strategies and money managers were not always on the right side of the market. It was not until 1951 until a man called Jack Bogle came along with his senior thesis called: “Mutual Funds can make no claims to superiority over the Market Averages.”, where he pointed out that if someone would buy the entire US Equity market, then this person would probably beat over two-thirds (or more!) of the actively managed mutual funds while at the same time achieving the average return of the market.
Of course his hypothesis was greeted with scorn and it was deemed “un-American”. Who, after all, would like to belong in a group of “average” investors? Nonetheless the first market tracking, low cost, passive index fund was created by Mr. Bogle in 1975 with a meagre $11 Million in Assets under management. Today, his index funds are among the biggest players in the financial markets as investors reach out to benefit from the many advantages.
2.Why Index Funds?
When someone invests in a stock, then he is expecting to make money from it. Unfortunately there is risk associated with this, since it is possible to lose the entire investment if the company goes bust. This risk is called unsystematic risk, and it refers to this single stock/company. Then there is the market risk, systematic risk, which is the risk of the entire market. When bulls are on the loose, then a large chunk of the equities available for trading are usually rising, and when the bears ruin the party then it’s time for them to drop. When investing in a single stock then the investor carries unsystematic risk on top of the systematic risk. In exchange for that he expects a larger return.
When trading Forex the unsystematic risk is something entirely different. A value of a currency does not simply drop to 0, therefore one can assume that it will always be worth something. However country specific risks are able to cause massive gains or losses if certain economic conditions are met. It helps to imagine that a currency pair, the EURUSD for example, swings like a pendulum around a middle point, sometimes up, sometimes down, depending on how the two economies are doing relatively to each other and the world.
For long-term investors, the future is as cloudy as it can get. No one can predict which companies will make the cut, and even large blue chips can go belly-up if they fail to adapt to the future needs of its clients. For example, the only company who is still in the Dow Jones Industrial Average since its inception is General Electric – and even they have been dropped now and then. Kodak, a household name in the 80’s and 90’s has declared bankruptcy in 2012.
This type of risk has to be eliminated when someone is thinking to invest for the long term. Since it is impossible to predict which companies will make the cut 10, 20 or even 40 years from now the investor has to build a portfolio of dozens of stocks, which he would need to analyze and select in his own time. On top of that he would have to pay brokerage fees when buying or selling his stocks.
Thanks to index funds however, it is much cheaper and more effective to invest in stocks than it has ever been. In a few clicks of a mouse the investor can buy a share in a fund tracking the S&P 500 for example. With this investment he is invested in all the 500 (501 as of today) companies of the S&P500 index, without the need to purchase 501 separate stocks and rebalancing them all the time. He will earn the average return of the US Equity market, receive dividends, and on top of that he doesn’t have to worry about unsystematic risk. Since an index fund tracks an index it will always automatically contain the given stocks, as long as an equity market in the US exists.
3.Past performance is not…
Necessarily indicative of future results. Most of us have heard this phrase. But since it is so well documented it’s easy to check how the market as a whole has fared during the last 100 years. During 100 years there were 2 world wars, and so many economic downturns worldwide it’s pointless to count. The compound annual growth rate of the S&P500 since 1900 is around 7%. That means that for a decade’s long investment horizon it is not too unreasonable to expect at least 7% return. This is more than enough to allow for a comfortable retirement after a working career. It is important to note however, that the markets are usually very volatile. The S&P500 has seen gains and losses of over 30% in some years.
Expectations when trading Forex
Now that we have covered a lot of ground regarding index funds, it is time to compare that to a self-traded Forex account. As mentioned previously, a long term investor in an S&P500 can expect to have an average return of 7% annually. Not too bad. But at the same time a trader who has some experience and uses a bit of leverage can sometimes make this amount in a single day. Obviously a self-traded account can be much more volatile, and it is necessary to have a good trading plan and money management strategy. The possible reward however is much higher, and many people spend a couple of hours a day in examining charts, reading up on fundamental news in order to trade a few currency pairs – and they do so successfully. But this comes at a price, as it is usually preluded by years of experience. It is not impossible however, and even an “Average Joe” can do it. A successful trader can expect to beat the “market” and earn at least 15%-20% a year on his forex trading account.
As a summary, investing in index funds is a perfect alternative for those who do not have the experience or time to select and analyze various stocks. Forex Trading can also be time consuming, as the trader has to be in front of the screen to find the best setups and to analyze the markets. It gives however a very useful skill set: after mastering the art of trading forex, one can expect to earn a positive return on his account for as long as he keeps trading, which is invaluable in today’s society of mass-layoffs and market turmoil.
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