Index funds

I try to keep an open mind in life; basically, as the facts change, my opinion changes.  Over the past few years, I've been studying investing and related topics, and believe me, there are thousands of people out there, each of whom claim to have found the secret to making it big in the stock market, and they all say everyone else has it wrong.  So far, the best advice I've found is from people who take a long term approach to it.  Basically, they say you need to do some research, put your money in a mix of stuff, and leave it there, for like 50 years, tweaking it every so often.  What you DON'T want to do is become a day trader; basically one of those people who makes money (or tries to, anyway) by buying and selling stocks, trying to capitalize on the fluctuations of the market.

On the surface, this looks like a good idea.  Buy a thousand shares of Apple stock at 10 am at $70 each, and sell them at 3 pm when they're at $71.  Hey, look at that, you just made a thousand dollars!  Not bad for a single day's work. But what happens if it goes down, to $69 a share?  You've just lost money.
Let's keep with the Apple theme, since it has the largest market capitalization in the world.  If you had invested money in Apple 10 years ago, in the summer of 2004, your money would have increased by over 4,200%.  That's 42 times what you put in.  $10,000 in Apple stock in 2004 would have turned into $429,786 today.  That's including the Great Recession.  Of course, this isn't typical.  Most stocks don't go up by that much, but what I want to impart to those who worry every time the market dips for a day or a week - Apple was down on almost half of the trading days during those ten years.

That's just like the stock market.  In the short term, it goes up and down randomly, but fortunately over time it goes up more than down, and money is made.

Now we get to the meat and bones of this article.  I recommend investing in index funds over individual stocks.  Feel free to skip this paragraph if you know what they are already, but for those who don't; they're a type of mutual fund that have most of the same stocks as an 'index', such as the Dow Jones or the S&P 500.  A mutual fund is a group of stocks you buy together, and the idea is that if one stock's price goes down, others rise in value, bringing up the value of the entire fund.  Here's how it works (borrowed from here):

Imagine you start with a $1.00 investment.  In any given year, your investment can go up by 30% or down by 10%.  It's essentially random, much like the flipping of a coin.  If the coin comes up heads, your investment goes up by 30%.  For tails, you lose 10%.  So after the first year (first coin flip), one of two things will happen:
- Your investment is up by 30% so you have $1.30
- Down by 10% so you have $0.90

Either way there's a 50% chance of it happening.

But if we split our money in half and add a second coin (a second stock), there are one of four possibilities:
- Two heads: both fifty cent chunks went up by 30%, making them worth 65 cents each, totaling $1.30
- Two tails: Both are down to 45 cents each, totaling 90 cents.
- One head, one tail: One half is worth 65 cents, the other is 45 cents, totaling $1.10
- One tail, one head: One half is worth 45 cents, the other is 65 cents, totaling $1.10

Now, each of these outcomes has an exactly equal chance of happening, 1 in 4.  But notice that in three of the scenarios, you earn money and in only one do you lose money.  Over time, flipping one coin or flipping both will give you the exact same long term returns: an average of 10% per flip.  But flipping both coins makes it much less volatile.

If two stocks can reduce the risk by that much, imagine what dozens, or even hundreds, could do!  That's essentially a mutual fund.  And I like index funds better because the fees tend to be lower.