- [Voiceover] Another type of financial institution is an investment fund. Remember, a key aspect of investing is that we can reduce our risk through diversification. Don't put all your eggs in one basket. But that can be kind of tough. Let's say I've got $3,000 to invest. It's kind of tough to take that $3,000 and split it up and invest a little bit here and a little bit there and spread it out among 25 or 30 investments. An investment fund company helps me do this diversification, for a fee. So here's what happens with an investment fund.
First, you send them your money, with instructions, here's how I want you to invest it, they'd then invest on your behalf. They do some work on your behalf. You're gonna then have to pay them a fee, and when you want your money, you will notify them, online, give them a call, send them a letter, and they'll send your money back to you. So they efficiently diversify your investment given your instructions, and they're gonna charge you a little bit of a management fee. It's a very efficient way to allow individual investors, people like you and me, to diversify our investments, a key function of investment funds.
There are different types of investment funds. Index funds, managed funds, private-equity funds, and hedge funds, all of these you've heard about so let's talk about them. We'll start with an index fund. Think of an index fund as a computer. I send in my $3,000 to the index fund, and say, "I want you to invest this "according to a mathematical rule." Pick the 500 largest companies in the United States, and just spread out my $3,000 investment among those 500 companies, don't think, don't try to pick which companies you think are gonna do well, which companies you think are gonna do poorly, just invest based on that mathematical rule.
Or maybe, the 1,000 largest companies in the world. Or some simple mathematical rule. Index funds are very popular because their management fees are very, very low. One popular index fund, the S&P 500 Index Fund, you can invest in for management fees, I've seen them as low as 0.05 percent per year, meaning if you invest $10,000 in an index fund, an S&P 500 Index fund, you're only gonna have to pay five dollars to have that watched over and managed by, for you for an entire year, that's a very low cost.
An alternative to an index fund is a managed fund. Think of a managed fund as a room full of experts, who spend all day looking at economic news and financial reports for companies and certain industries and so they can then give you an informed recommendation. You send us in your money, and we think you should invest in this company, and this company, and not that one. So of course, you're gonna have a little bit of advantage if you invest in a managed fund compared to an index fund because an index fund, it's just a computer based on some mathematical rule.
A managed fund is managed, experts specifically and strategically decide where to invest your money. But, those experts have to be paid, so for example, it's not unusual for a managed fund to have a management fee of three or four percent per year. So that same $10,000 investment that I can put in an index fund and only pay five dollars a year to have it managed, for a managed fund, I might have to pay $300 or $400 to have it managed. So there's the trade off, do I want low management fees with an index fund where I'm not strategically investing my money, or do I want to go with a managed fund? And that's a choice that investors have to make.
You've also heard of private equity funds. Private equity funds are not for you and me typically. These are big investment, $100 million dollars, where a group of people with lots of savings have put their money together and say, "We're not gonna invest in a few shares "of stock, we're gonna buy companies." That's what private equity funds do. And it's not so easy to get your money out of a private equity fund because you have put your money in with other people, large amounts of money, and you've bought other companies, and so it's not easy to pull your money out.
Finally, you've heard of hedge funds. A hedge fund, think of it as a very sophisticated mathematical organization that has done statistical tests and found relations among US dollars, Indonesian rupiah, and stock prices in the Indonesian stock market, and have used those mathematical relationships to come up with very sophisticated rapid trading strategies, and they're gonna invest your money on that basis. Not for the faint of heart, and for private equity funds involving large amounts of money, and hedge funds, typically regulations around the world would prevent ordinary people who aren't sophisticated who don't know what they're getting into from getting into those kind of funds.
Anybody can be in an index fund. Anybody can be in a managed fund. But a private equity fund or a hedge fund, those are for sophisticated investors with lots of money. Now the S&P 500, let me tell you what that means. S&P stands for Standard and Poor's, just the name of a company, 500 represents the 500 largest companies in the United States. The most popular index fund is the S&P 500 Index. So this graph here shows you, that if you had started out with a small investment in the S&P 500 Index Fund back in January 1950, what would have happened to it from then up through October 2013.
And you see it kind of toddles along and starts going up, and it goes crazy around the year 2000. That's the internet bubble right there. So that first peak is the internet bubble. Bubbling, and then bursting. And then things went up again. That next peak there is the global hysteria over housing prices and mortgage-backed securities and various other things, that was the housing bubble, primarily in the United States, but it contaminated everywhere else in the world. And then that burst, and led us into the global recession in late 2008 and 2009.
So we've got two peaks, and then drop-offs from the bursting of bubbles. You'd think we learn our lesson over time. In fact, it should make you a little bit nervous to see another peak building off to the far end of that graph, but what you should look at, is this. For investors who are long-term investors, the S&P 500 Index can be a very prudent investment. I'm not selling investment advice here, and past performance is certainly no indication of future performance, but if you invested your money clear back in 1950 and just let it sit there and didn't get too excited during the internet bubble times, and didn't get excited during the housing bubble times and just let your money sit there, you'd be now in October 2013 about where you wanted to be.
So, index investing is for people who just want to put their money in, and let it sit there. An S&P 500 Index is a common benchmark. If I'm managing an investment portfolio, I want to at least beat the S&P 500 Index, because remember, what's the sophisticated investment strategy used with the S&P 500 Index? Just tell your computer to spread the money out among the 500 largest companies in the United States. Not much analysis needed there. So investment managers are always comparing themselves to, "How did I do compared to the S&P 500 Index?" If I can't beat just randomly investing in the 500 largest companies in the United States, maybe I ought to get in another business.
The most famous investor in the United States is Warren Buffett, and every year he writes a President's Letter for his company, Berkshire Hathaway, you should read those sometimes cause they're very interesting, but he, every year, says, here's how we did this year compared to the S&P 500 Index. And he shows, for example, that since he started running the company back in the 1960s, the S&P 500 Index has gone up about 10 percent, and his company's performance has increased at an annual rate of about 20 percent.
He has beat, on average, the S&P 500 Index. Not every year. In fact, one year, he famously was quoted as saying, "I didn't do very well this year. "You would have done better this year "if I had gone to the movies all year, "rather than try to pick investments, "because the S&P 500 Index did better." Now, you might look at this and say, "Okay, here's evidence that I can pick "investments in the stock market." Look, Warren Buffet has earned 20 percent over the last 50 years and the S&P 500 Index has only earned 10 percent, he can pick stocks, I ought to be able to pick stocks.
Well, let me tell you something. As soon as you have as much information as Warren Buffett does, you can recreate his performance. Warren Buffett sits in Omaha, Nebraska and considers deals all year long. People are always proposing deals to Warren Buffett. "Hey, would you like to buy my company? "And here's the price, and here are the details." He considers hundreds of deals per year, and invests in only a handful, but he gathers all kinds of information. So if you become an expert, and you are presented with all kinds of extra information, you too can probably beat the S&P 500, 500 Index.
I'm just gonna tell you what I do. I don't think I can beat the S&P 500 Index, so for my personal investing, I just trust that if I've spread my money evenly among the 500 largest companies in the United States, I'll probably do okay. Not as good as Warren Buffet, but I'll do okay.
- Understanding financial statements
- Managing finances in the short term
- Analyzing risk and return
- Obtaining short-term and long-term financing
- Understanding the stock and bond markets
- Comparing the Facebook and Microsoft IPOs
- Working with financial institutions
- Using capital budgeting
- Creating simple personal saving and investment plans