Have you heard of investing in index funds? On more than one occasion, we hear specific terms out of the norm that stand out for their uniqueness and that appear in conversations about recommendations, in expert forums, and on opinion pages. In finance and investment, the same thing happens with index funds: a product that, without being new, is beginning to “grasp front pages,” among other reasons due to its versatility and the above-average benefits it offers to a particular investor profile, but to what specific profile? What are index funds, and why should we consider them when investing?

What are index funds?

We could define index funds as a “thumbnail” of a financial index in a simplified way. In other words, they have known A financial instruments whose intention is to replicate the behavior of a specific index -for example, a stock market index-and which, therefore, determine their success or losses based on the evolution of the replicated barometer.

For example, if we decide to replicate the German DAX30 (where companies of notable solvency such as BASF, Bayer, BMW, Deutsche Bank, SAP, or Siemens are listed) if this indicator closes positive, our fund will obtain benefits in the proportion invested.

These funds fall within the classification of passive or index management funds by their very nature. And what are passive investment funds? Those funds that are exclusively dedicated to replicating a benchmark (reference index), contrary to how actively managed funds behave, those destined to beat the benchmark do everything possible to obtain profits above them.

Thus, while the passive management proposed by index funds limits all action to replication, active management requires more excellent knowledge and more significant resources that allow “going ahead” of the referenced index, which means that we would spend nonstop action from observation.

Why invest in index funds

The first thing is to indicate that there is no better or worse financial product than others (if so, we would all invest only in the best ones). However, better or worse,

products adapt to our profiles and financial needs. For this reason, the most advisable thing before investing in index funds is that we do so according to the results of a test that can indicate our aversion to risk.

These tests are usually offered before starting the fund managers’ investment. According to the results, they distribute the amounts by building a portfolio of index funds depending on whether they support greater or lesser risk.

Once this point has been well clarified, it is recommended to invest in index funds when we are a long-term profile that flees from products that require a specific “nerve” (such as those that are classified as actively managed) by limiting themselves to replicas of the movements of the index; it is usually done automatically through Robo advisors (a concept that we will detail later), adjusting the portfolio when the investor profile changes.

Thus, without only limiting the use of index funds to these profiles, it is the “star” product for those who have a certain amount of savings (from 3,000, although more significant amounts are desirable) who want to increase it in the long term, without caring that it is immobilized for greater profitability (although, like all financial products, early withdrawal is also contemplated), being able to make frequent contributions that act as deposits that increase the desired profitability.

In practical cases, we could see it in parents who save for the university expenses of their pre-adolescent children, 40-50-year-old workers who are already thinking about their retirement and want to set up their pension plan, or savers with specific 10-year goals. Fifteen years as the purchase of a second property. Not excluding those who simply care about growing their savings.

Risk profiles in investing in index funds

Index funds are financial products whose composition is closely linked to the risk profile, that is, the level of assumption of losses that we can bear. Therefore, we are already assuming risk by investing in index funds, however minimal it may be. From here, depending on whether we risk more (and with this, we intend to obtain more excellent benefits) or less, the composition of our index fund portfolio will vary.

This exercise is carried out professionally by the Robo Advisors. They propose an optimal portfolio construction by formulating specific questions about our financial level, objectives, and risk aversion. However, there are usually four

variants that have the most significant weight in the construction of the risk profile in index funds:

– Age:

The younger we are, the more capacity to assume the risk of high-yield investment.

– Fear of economic loss:

The more apprehensive we are about losing money, the more tense a situation of economic crisis makes us, and the less risk we must assume.

– Investment terms:

Short-term investments tend to be more conservative, while those designed for the long term (index funds) tolerate more significant risk.

– Income stability:

The more insured a recurring economic source is, the more risk can be assumed.

And in terms of these variants, how do you know what amounts to invest in index funds?

There are “artisanal” formulas such as 110 (subtract our age from 110, and the figure that gives us the result will be the optimal total percentage that we should allocate from our savings to index funds, leaving the rest as a fixed-income deposit). Thus, if we are 40 years old, according to this formula, 70% of what is saved would ideally be destined for index funds.

The issue with this formula is that it does not take all four factors into account, omitting two of the most important: aversion and stability.

This is solved through the mathematical formulas that Robo Advisors apply when analyzing the profile of each client, through questions such as:

– Investment objective

– Deadlines set for the withdrawal of money

– Level of risk assumption

– Percentage of bearable loss

– Age

– Employment situation

– Income level and annual savings

– Patrimony

Taking all these factors into account, they indicate the optimal amount to invest in index funds, which you can, in turn, modify to suit your risk profile more specifically or the amounts you expect to achieve in X term.

Investing in index funds with Robo advisor

Those known as Robo Advisors, as we have already had the opportunity to reveal, are the technological tools that allow us to manage the portfolio in index funds without the need to constantly review their results, which is precisely what we are looking for when we talk about products and returns to long term.

Robo Advisor comes from the English terms robot + advisor (robotic advisor). Although the use of the robot concept can dissuade us (no one likes that something as vital as their savings is in the hands of technology alone), really what it is about is the use of technological tools that allow automating the management where the resources Human resources do not add value, but under the supervision and control of the advisors (for example, when designing the risk profile).

Thanks to these characteristics, the Robo Advisors can reach where the advisor would take much longer to offer the same information (since they follow their guidelines), helping make investment decisions and check that they are followed correctly.

In this way, within the tasks that a Robo Advisor solves, we find the following:

– Construction of the investment profile: as we have just seen in the previous section, these are the tests that will build our risk profiles and, in key to it, will guide our investment and its objectives to be achieved. These tests build the profile based on the factors that influence the investment, avoiding randomness or relying solely on information about our assets and age.

– Rebalancing, reinvestment, and contributions to the initial investment: one of the values of the financial product to choose that we have emphasized is that it should offer us peace of mind and be easily manageable in the long term. In this sense, the Robo Advisors automatically execute the recurring contributions that we have programmed according to our savings plan and show us the situation of our investment at all times, allowing a rebalancing (change of profile) if necessary.

– Detailed, helpful information at all times: it is how, ultimately, it shows us how the investment is going. One of the benefits we attributed to passive management products such as index funds or ETFs was their easy monitoring (if the replicated index does well, so makes my investment). However, as our stock portfolio ages, needs may arise not contemplated at the beginning of the investment, either for the better (our capital increases) or not so much (our employment situation changes). At least once a year, we will have the opportunity to update our investor profile and thereby maintain or change the status of our securities portfolio.

Examples of Investments in Index Funds

We have seen how reference indices such as the IBEX35 or the German DAX can be replicated but is it shared? It will be to the extent that, according to our profile, it determines it (although we must tell you that the IBEX35 is not usually taken as a reference to seeking returns in professional portfolios, which are made up of more complex indices such as the MSCI World). Thus, if several indices replicating will allow us to reach the objective more quickly in the indicated time, these will be the ones that make up the portfolio.