Instead of investing in individual stocks of individual companies, which is inherently risky, chance based, and that you often have far less information about than competitors, the safest and most effective way to invest in the market is to put your money in broad-based indexes, which minimize risk and are much easier to make money from consistently.
What is a Broad-Based Index?
Broad-Based Index are those designed to coincide with the movement of entire industries. Some of them are very small: Dow Jones Industrial Average is 30 stocks. The largest is the Wilshire 5000 Total Market Index.
The point of investing in such indexes is diversity, and the reason that’s a valuable trait in investment is the law of averages.
How Does Diversity Benefit Investment?
If someone has a pair of six sided dice, and asks you to bet on an outcome between 2 to 12, what are you likely to bet on? If you know anything about probability distributions, you might recognize that two six-sided dice are much more likely to result in the middle values than the end ones, simply because there are more combinations that result in, say, 7 (1+6, 2+5, 3+4, 4+3, 5+2, 6+1) than 2 (1+1) or 3 (1+2, 2+1).
Now what if they say that your payoff is higher the lower the chance of the result? It might be worth it if the investment is small enough and the payoff big enough, but the guy with the dice is no fool: he won’t offer you good enough odds to have a strong chance of making money from him. And of course even if you are offered good odds, the chance of the roll landing on exactly the number you pick is still going to be lower than all the other numbers it can land on.
But what if he offers you a hundred rolls with a hundred bets, and you can bid different amount on each possible result?
That’s what Broad-Based Index do. They take your bet, your investment, and essentially spread it out over a whole group of industries within the same market, so that even if a few of them drop in value or fail, the rest are likely to benefit from that failure and go up in value.
The difference in the analogy is that dice rolls will always be within the same parameters, while industry stocks can trend upward or downward over time.
So now imagine that the dice roller offers you only two options: 2-8 is one bet, and 9-12 is the other. If you lose money every time it’s 9-12, and gain money every time it’s 2-8, and it’s the same amount of money bet and lost in both, then over a long enough timeline of rolls, you will eventually see an upward trend of how much you win.
That’s not to say risk is completely eliminated of course. There are rare occurrences where an entire industry will tank, like when the real estate market collapsed and kicked off the Great Recession.
But that, again, is why diversity is so valuable. The more places you have money invested, the less likely you are to lose everything you invest, and the more likely you are, over time, to get a return on investment.
So Broad-Based Index Will Make Me a Millionaire?
Probably not, or at least not anytime soon. Remember, the point is betting a little over a lot of rolls. It takes time for the law of averages to come into play and pay off incremental rewards.
The difference is that most industries as a whole are profitable, and it’s far less likely that you’ll lose all your money on an industry collapsing than an individual business. It’s the difference between winning a million dollars if you can correctly predict where lightning will strike in a field, and winning 5 dollars every time lightning strikes anything.
The key to making money from the stock market is time and patience, through diverse investments.
