Strategies for the successful investor part 6 :Index the market

Like i said in my previous post trying to outperform the market is a waste of time. The way to go is through index fund or mutual fund since it is rare that someone can outperform the market consistently.

So what would you do if you are investing in traditional assets like stocks and bonds. You have to try to index the market.

What you should do is to invest in companies that are of different sectors of the economy. You will thus select a number of different companies to invest in. What you would do is to add the market capitalisations of all the companies that you want to invest in.

Then if you want to invest in a company X you will have to invest  money in company x acording to the equation below

Money invested = (Market capitalisation of x/total market capitalisation) * money that needs to be invested

You might want to create a spreadsheet to help you determine how much to invest in each company.

Now the indexing will not be similar to a professional index fund but it will approach it if you

1. Choose a large number of sectors of the economy to invest in such the companies you invest in will make your portfolio representative of the economy.

2. in each sector of the economy that you invest in you select a few companies that will be representative of that economy. You will thus invest in a series of mega cap, large cap and small cap companies.

Similarly you will invest in bonds such that you will invest in securities with a wide range of maturities and issuers. Hence your bond portfolio will be spread across municipal bonds, corporate bonds and government bonds. You will also have to invest in the money market and capital market bonds so as to spreads your exposure to different maturities of bonds.

What are treasury notes?

Treasury notes are securities that are issued by governments in order to raise funds to finance deficits. It has a maturity that ranges from 2 to 10 years. Hence it is a security that is traded in the capital market. the capital market is the market in which securities that has a maturity of more than 2 years are traded. treasury bonds is also a security that is traded in the capital market.

The treasury notes are issued at a discount and at maturity the face value is paid to the holder of the notes. The holder of the notes is also entitles to a coupon which is like an an interest paid on a certificate of deposit. This coupon is paid according to a coupon rate which  is merely the percentage of the face value of the note that would be paid as the coupon.

The 10 year note is often used to have an indication of future inflationary expectation. It is often used in the bond spread which is the difference in yield between the 10 year note and the three month treasury bill. The three month maturity date is considered to be so close in the future that the inflation in three month will be close to the actual inflation. The 10 year maturity date however is sufficiently far in the future that the inflation at that time cannot be known. However investors will want to ensure that the yield on the ten year note is adjusted for inflation. Hence the difference between two will be the expected inflation in ten years. The difference in the two yield cannot include a  risk premium like the corporate or municipal bond yield because government treasuries are considered to be the safest of securities.

Government securities: Bills, notes and bonds

Government securities are debt instruments that are issued by central banks with the aim of raising funds to finance government deficits. They can also be issued as a result of monetary policy where they are used to drain liquid. Although government usually prefer to use longer maturity to finance deficits while central banks usually like short-term maturity securities in monetary policy.

Types of government securities

There are four main types of securities that government issues

1. Treasury bills 

2. Treasury notes

3. Treasury bonds

4. Treasury inflation protected securities (Tips)

These securities given the fact that they are issued by the government they are considered to be quite safe. However you should be aware that not all government securities are safe. Investors should remember examples such as Argentina defaulting on its bonds or Dubai trying to dodge  out of its obligations by asserting that legally the bonds are not issued by the government but by a separate entity control by the government.  

These government securities are also highly liquid. In fact government securities are  the most traded of all securities. This is because by law banks, insurers and other financial institutions are required to hold a certain percentage of safe assets on their balance sheets. Hence a lot of these institutions hold government securities to reduce risk in their portfolio.

The increased liquidity comes from the fact that these institutions needs to have access to their funds at short notice. However when they do not need their money they need to invest it in a safe asset that they can sell easily. Hence this add to the increased liquidity of the government securities.

These securities can be obtained from two ways. Either over the counter at central banks and with financial institutions or though a system of auction at which financial institutions bid for them. we have already seen this system in the post on treasury bills.