"Foolproof Investment"

Summary of "Foolproof Investment" Everyone Should Master:

Introduction of a simple and feasible 50/50 investment strategy
How to combine it with the investment methods discussed by Qian Jun
Excerpts from "Foolproof Investment"

The "Simple" 50/50 Strategy#

I recently read a great book, "Foolproof Investment," which gave me a lot of insights (I immediately added it to my "Recommended Reading List"). The author's biggest highlight is that it lowers the threshold for investment strategies to a very beginner-friendly level, allowing novice investors to learn simple asset allocation through this book, outperform the market, and become part of the top 10% of investors who consistently lead the market.

Foolproof Investment

At this point, you might doubt my claims about why a simple strategy can help someone become part of the top 10% of investors outperforming the market. What are the other 90% of investors doing? In fact, the author has already answered this question in the text, and it contains one of the most insightful statements I've heard in my years of learning about investing. Read on with this statement in mind, and I believe you will gain more insights.

Action is based on thinking and cognition; if cognition is lacking, the implementation of action will naturally seem exceptionally difficult.

Most stock investors desire a lot and do a lot, but due to cognitive limitations, they end up worse off than those who do nothing, losing more as they try harder. Why is this strategy so simple yet no one executes it? The answer is also due to cognition.

The strategy provided by the author is very simple: a 50/50 ratio, with 50% invested in market index funds (such as the CSI 300 Index Fund, hereafter referred to as "stocks") and 50% in money market funds (such as Yu'ebao, hereafter referred to as "cash"). Due to market fluctuations, stocks will rise and fall, and by the end of each year, this ratio will no longer be the standard 50/50. At this point, you need to perform dynamic balancing to readjust the ratio back to a 50/50 balance.

This investment strategy, when viewed over the long term (more than 10 years), has a very high probability of outperforming 100% index funds, essentially making it unbeatable.

So, how can 50% of investment beat 100% of investment? Actually, Qian Jun has highlighted this for everyone—dynamic balancing.

How should dynamic balancing be understood? It actually implies a "buy low, sell high" strategy, requiring you to sell off assets that are performing well and buy into those that are performing poorly or even declining. For example, if you start with a 50/50 allocation at the beginning of the year and the stocks double in value, by the end of the year, the actual ratio becomes 66.6/33.3. You need to sell some stocks to readjust back to a 50/50 ratio.

This investment logic is easy to operate, requiring at most half an hour each year, but it requires a strong cognitive logic to support it. In summary, it is easy to start, but hard to maintain.

First, selling when the stock market is booming and buying when a market crash occurs is inherently counterintuitive;
Second, during a market surge, the 50/50 strategy means your income is only half that of other investors, making it easy for even new market entrants to surpass you. In such a market, how can you stick to your strategy?
People tend to focus on short-term gains, and the potential returns of a long-term strategy like 50/50 can easily be overlooked.

How to Integrate the 50/50 Strategy into Your Investment System#

In the financial management system advocated by Qian Jun, at least six months' worth of living expenses should be retained as emergency funds, which should be held in the form of money market funds (like Yu'ebao). This fund can completely overlap with the "cash" portion of the 50/50 strategy, optimizing the allocation of financial resources.

Since the emergency fund investment overlaps with the "cash" portion of the 50/50 strategy, you can consider the "cash" in the 50/50 strategy as your emergency fund. However, there is a prerequisite: you must have enough self-discipline. If you need to withdraw from your emergency fund, you must replenish it as soon as possible.

Assuming A has a total of 200,000 in funds, originally holding 60,000 as an emergency fund, after starting the 50/50 strategy, you can stop setting aside a separate emergency fund and directly allocate 100,000 to index funds and 100,000 to money market funds.

However, if the cash portion in the 50/50 strategy is insufficient to cover the emergency fund, you still need to establish a separate emergency fund to make up the difference. Using A as an example, if there are 100,000 in funds, you would need a separate emergency fund account of 20,000, leaving 80,000 to invest in the 50/50 strategy, thus the total cash portion would just cover the 60,000 (in practice, it’s best to leave some margin and not push it to the limit).

In this way, we have integrated the simple 50/50 investment strategy into the current financial management system, achieving a balance on both ends.

Additionally, the 50/50 strategy can be adjusted flexibly based on your investment time horizon, not just limited to a strict 50:50 ratio of stocks to cash. However, please note that the required adjustments should match your personal cognition. If you have little investment experience, simply maintaining the 50% ratio is advisable; overcomplicating it may be counterproductive.

Key Quotes from "Foolproof Investment"#

"Foolproof Investment" is a thin book, and I strongly recommend it to anyone interested in financial management; it can be read in 2 to 3 hours. Below are some excerpts and insights from my reading, with the quoted content in quotation marks.

"Action is based on thinking and cognition; if cognition is lacking, the implementation of action will naturally seem exceptionally difficult."

I used to struggle to understand why some simple investment rules are even harder to apply for beginners. The reason is simple, yet no one executes it until I read this statement. This is my biggest cognitive gain from reading this book: simple actions often require a more complex and robust cognitive system behind them; as the saying goes, "one minute on stage requires ten years of practice off stage."

My second major takeaway is that I have truly begun to establish my second type of investment account according to the logic of asset allocation, a long-term strategy akin to the conservative end of a barbell strategy. This account is implemented through the "Ant Wealth" app, with 50% in stock funds, 25% in bond funds, and 25% in money market funds, rebalancing annually.

"Rebalancing is key."
"Asset allocation implies an inherent attribute—counter-cyclical investment (buy low, sell high)."
"Asset allocation strategies essentially boil down to two questions: one is to determine the allocation ratio of different asset classes, and the other is to execute the 'rebalancing' behavior."
"The key to whether 50:50 can perform well lies in whether one can steadfastly execute rebalancing during the most frenzied market rises (selling stocks to convert back to cash) and whether one can persist in executing the rebalancing strategy during the most dismal and pessimistic times in the stock market (buying stocks)."

"Over the years, although I have repeatedly read Graham's 'The Intelligent Investor,' and even to avoid the bad habit of skimming through long-form web novels, I have painstakingly copied investment classics like 'The Intelligent Investor.' The effect of reading slowly and savoring is evident, yielding great rewards. However, when I copied Graham's '50:50 formula' (equivalent to a half-position strategy), I couldn't help but think, such a simple method, who would follow it? It would be a miracle to make money."

So, it is said that the speed of reading should not be the focus; some books are more meaningful when read slowly.

Over time, I gradually learned the so-called "skills" of communicating with clients—more often becoming a "listener" and "agreeer." Using the answers that already exist in the client's mind to respond to their questions.

This is also a significant reason why losing investors find it hard to change; all their questions already have answers in their minds (but often wrong), so your responses cannot change their views. Many practitioners, out of helplessness, can only answer questions in line with the investors' thoughts.

To become a superior investor, one must start from within; one must first admit they are a loser before humbly accepting others' viewpoints. Be foolish is very important.

"We need financial management, not investment."
"There is no need to present family financial management and personal investment in an overly professional manner; sometimes, all we need is a 'Family Medical and Health Knowledge' book, but what we get is 'Human Anatomy.' In investment, there indeed exist some more fundamental yet extremely important and practical knowledge. This knowledge can serve as the foundation of the investment knowledge system and can also greatly assist amateur investors."

Too many people view financial management as overly complicated and difficult, leading to confusion. First, clarify the difference between financial management and investment before making a choice. If you only need financial management, the 50/50 strategy is sufficient; concepts like value investing, trend investing, and technical analysis have nothing to do with you.

As everyone continuously raises their opportunity cost of investment from 2% to 8%, you will find that the stocks you wanted to buy no longer seem appealing.

Chapter 1: Advice for New Fund Investors#

1.1 If you want to become rich, you must accumulate assets.
If you are like most people and do not have much money at hand, the first thing you need to do is save money. There is a very popular financial book called "Rich Dad Poor Dad," which is a good introductory book on financial management. It introduces a very important financial viewpoint: spend less, save more, and invest the saved money into income-generating assets. But what is consumption? What is an asset? Can you distinguish between them? Here, I will answer with a simple example.

Suppose your company gives you a bonus of 1,000 yuan, and you spend that 1,000 yuan on cigarettes; that is consumption. If you use that 1,000 yuan to buy Yu'ebao, that is buying an asset. When you buy cigarettes, once you smoke them, there is nothing left, while Yu'ebao can help you appreciate your money and generate income.

True wealthy individuals hold a large amount of assets but would never pay for consumption they cannot afford. For example, Bill Gates often spends lavishly, but he holds the largest asset—Microsoft shares. Warren Buffett is known for his frugality, having worked in the same office building in his hometown for decades, despite holding hundreds of billions, he never craves vanity.

Reducing consumption does not mean becoming a miser like Scrooge; it means consuming more rationally. When our monthly salary is only 5,000 yuan, we should not think about buying the latest iPhone; when we buy our first car, we can choose a model with a better cost-performance ratio; when our time is not worth much, we can spend our spare time reading more, exercising, and cutting out some high-cost but unbeneficial consumption.

"A clever woman cannot cook without rice." In investment and financial management, we must first have money. If we are more pragmatic in our consumption, we can save more money for investment and more quickly embark on the path of "money generating money." This way, investing will become easier, and we will achieve financial freedom faster.

1.2 Find the assets with the highest long-term returns.
There are many common assets in daily life, such as gold, government bonds, bank wealth management, P2P wealth management, stocks, real estate, commemorative coins, and commemorative banknotes, all of which belong to assets. So which one should we choose? Which one has better long-term returns?

Here, we need to mention a concept: cash flow. Some assets can generate cash flow. For example, if we buy a 10,000 yuan 5-year government bond (book-entry), with an interest rate of 3.5%, we can receive 350 yuan in cash interest every year on June 1. This is the cash flow from government bonds. Many assets can generate cash flow, such as bonds, stocks, real estate (which can generate rental income), bank wealth management, P2P wealth management, etc.

Some assets cannot generate cash flow, such as gold. If you properly store 1 kilogram of gold from 100 years ago until today, it is still 1 kilogram of gold, with no change. For instance, a Ming dynasty jade pendant, calligraphy, or furniture will not generate cash flow today either. These are assets that cannot generate cash flow, such as precious metals, antiques, artworks, and mines.

Why distinguish between cash-generating assets and non-cash-generating assets? This is because, essentially, the price drivers for these two types of assets are different.

For cash-generating assets, their price mainly depends on the size and stability of cash flow. For the same 5-year government bond, one with a 3.5% interest rate and another with a 4% interest rate, we would choose the one with the higher interest rate under the same risk conditions. If two banks issue wealth management products with a 5% interest rate, one from a large bank like China Merchants Bank and the other from a rural credit cooperative, we would naturally choose the large bank because its wealth management product is safer, with stronger cash flow stability, and we do not have to worry about repayment at maturity.

For non-cash-generating assets, their price mainly depends on supply and demand. We often hear the saying "jewelry in prosperous times, gold in chaotic times." Why can gold rise in price during wars? Because gold has good liquidity and its value is relatively universal, so during wars, the demand for gold rises, leading to a supply shortage and a price increase. All non-cash-generating assets have prices determined by supply and demand.

After all this, we still do not know which asset has the highest returns! Here is a general concept: cash-generating assets usually have higher long-term returns than non-cash-generating assets; among cash-generating assets, the higher the cash flow, the higher the long-term returns.

Professor Siegel, the author of "The Long-Term Secrets to Investing in the Stock Market," has statistically analyzed over 200 years of the U.S. financial market and found that stocks are the highest-yielding assets in long-term investments, followed by corporate bonds and short-term government bonds. Moreover, no bond can outperform inflation in the long term; only stocks can do that.

Assets like gold, which cannot generate cash flow, have long-term returns even lower than government bonds: over 100 years ago, 5 taels of gold could buy a courtyard in Beijing, but over 100 years later, 5 taels of gold can only buy less than 2 square meters in Beijing's fourth ring, far behind inflation. During the same period, the U.S. stock market rose from over 40 points to over 17,700 points, an increase of over 400 times.

Some friends may disagree: I have been stuck in stocks for many years, not only without any returns but also losing a lot of money. How can stocks be the best long-term yielding assets? This involves the issue of investment strategy. For the same PetroChina stock, Buffett makes money while you lose. What is the correct way to invest in stock assets? I will leave this as a teaser; after reading the following chapters, you will naturally understand.

1.3 Look at returns, but also pay attention to risks.
"One daily limit up," "monthly profits of 30% to get rich," what! Is there really such a good thing in the world? If someone claims they can easily help you achieve an annualized return of over 30%, or even a monthly profit of 30%, that is undoubtedly a scam.

Although stocks have the highest long-term returns, they also have limitations. We cannot expect stocks to bring us unreasonable returns. Long-term investing in stocks, without considering any strategy, can average a compound annual return of 9% to 15%; with the right strategy, one can achieve around 20% annualized returns. Some exceptionally skilled investors can achieve over 20% returns over decades. Do not underestimate this return; stock god Buffett has maintained over 23% annualized returns for over 50 years, making him the world's number one.

Next, I will discuss two major financial scandals from 2015: P2P and Jinchao Yang. Through these two financial scandals, we can see through most financial scams and avoid losing the hard-earned money we have made.

What happened with P2P?
In fact, not every financial scam starts with the intention to defraud; some collapse due to unreasonable design patterns, such as P2P.

P2P is a financing investment platform. The operation model of this platform is as follows: if a company holds metals, it can mortgage them on P2P at the platform's metal price; where does the funding come from? It comes from investors. Investors transfer their money to P2P, which then lends this money to companies, with the companies pledging metals as collateral and promising a certain return.

At first glance, this model does not seem problematic; many financial leasing and guarantee companies operate similarly. However, P2P has two notable differences that led to its collapse.

The first is high returns. When companies cannot repay loans, the platform can sell the collateral to recover cash, ensuring that investors do not lose their principal. P2P's main product is a daily gold treasure, which has high liquidity and promises an annual return of up to 13%. For wealth management products similar to Yu'ebao, a 13% return is very unreasonable; very few companies can bear such high capital costs, so in the end, companies have only two options: repay loans with collateral or borrow new to pay old, surviving one day at a time.

The second difference is that the collateral, i.e., metal prices, is based on P2P's trading price rather than the commodity market's trading price. The P2P price is much higher than the market's normal price, leading to the actual value of the collateral being insufficient to repay the loan.

P2P promised high returns to investors, obtained funds from them, and lent them to companies; however, companies could not bear high capital costs, and the assets pledged to P2P could not repay debts, leading to P2P being unable to recover its principal, resulting in increasing defaults, and ultimately, its collapse was not surprising.

What happened with Jinchao Yang?#

Although not as famous as P2P, Jinchao Yang's case involved even more money, making it the largest financial scam in the first half of 2015. Unlike P2P, which collapsed due to model defects, Jinchao Yang was designed from the start to defraud money.

"We joined Jinchao Yang to learn, first borrowing money to buy luxury homes or cars, using them as assets to continuously leverage loans from banks, then continuing to leverage operations to obtain funds, and finally investing some of that money into Jinchao Yang's Pre-REITs and corporate short-term bonds, with Pre-REITs having annual returns as high as 100% and corporate short-term bonds previously yielding up to 36%," said a former Jinchao Yang BCC student.

Jinchao Yang's income came from two parts: one was tuition fees, with the highest-level course costing around 80,000 for three months, and just from tuition, Jinchao Yang earned 28.8 billion; the other part came from the funds students used to purchase high-yield financial products. Jinchao Yang continuously used new funds to pay interest on previous financial products, making it a typical Ponzi scheme.

How to avoid financial scams?
P2P initially had government backing, and even banks helped sell it, while Jinchao Yang had many wealthy participants, making it seem very credible. However, these scams all share a clear characteristic: they promise unreasonable high returns.

P2P promised a daily return of 13% on wealth management products, while Jinchao Yang promised annual returns of 30% to 100%. In reality, no wealth management avenue can sustain such high returns. Even stock god Buffett, with an average annualized return of 23% over decades, is already at the top level globally. If any platform promises 30% returns to all participants, is that possible? Even if that platform is state-backed, unreasonable high returns cannot operate sustainably because finance has its own operating rules that cannot be violated.

Do not be greedy; avoid unreasonable high returns; all financial scams are paper tigers.

1.4 The Power of Compound Interest#

Einstein once said that compound interest is the eighth wonder of the world. Compound interest can turn seemingly mundane returns into unimaginable miracles over time.

Here is a small example.
In January 2015, the famous He Dong Garden in Hong Kong was sold for 5.1 billion HKD. Sir He Dong's investment rose from 66,000 in 1923 to 5.1 billion in 2015, appreciating 77,000 times.

While 77,000 times seems astonishing, what is the annualized compound return? 13%.

In other words, if you now have a correct investment strategy that can achieve a long-term annualized return of 13%, then your 100,000 will turn into 7.7 billion after 92 years! Conversely, if you lack the corresponding investment ability and only invest in 5% government bonds, then after 92 years, your 100,000 will only amount to 8.9 million, which is one-thousandth of 7.7 billion!

This is the power of compound interest.

The key to compound interest lies in how to achieve long-term stable investment returns. With so many investment tools available, which method is simple, feasible, and effective? Don't worry; below I will introduce the most suitable fund for office workers—index funds.

1.5 The Most Suitable Fund for Office Workers—Index Funds
We often come across the term "fund," such as stock funds, bond funds, mixed funds, and so on, which can often confuse people. What exactly are these funds for?

Simply put, a fund is a basket that can hold various assets according to pre-set rules. The advantage of this is that it divides a basket of assets into several small portions, allowing for investment with less capital, making assets that we could not afford to buy directly accessible through funds.

For example:

A basket filled with various short-term bonds, short-term wealth management, and cash is a money market fund.
A basket filled with various corporate bonds and government bonds is a bond fund.
A basket filled with stocks from various companies is a stock fund.
A basket filled with both stocks and bonds is a mixed fund.

As mentioned earlier, stocks are the fastest appreciating assets in the long term, so by buying stock funds, we can also achieve the fastest appreciation.

Currently, there are thousands of stock funds in China, and we cannot possibly understand each one in detail. Here, I recommend a special type of stock fund, which is the only type of fund that stock god Buffett has repeatedly recommended in public—index funds. Index funds adopt passive investment, selecting a specific index as a benchmark, purchasing all or part of the securities contained in that index according to the index's composition standards, aiming to achieve returns that match the index. By investing in stock funds long-term, we can also obtain the highest long-term returns among all assets. For ordinary investors, index funds are the best choice.

For example, the Hong Kong stock market has seen an astonishing total increase of 554 times from 1970 to today! The annualized compound return is 13.2%! If we hold the Hang Seng Index Fund, we can achieve such high returns. Even in the A-share market, which is often criticized, the overall increase since its inception has exceeded 40 times. If we hold an A-share index fund, we can average such returns.

In fact, even if we choose an index fund, there are still over 100 options available in the market. How should we further select?

Common index funds can be simply divided into exchange-traded funds (ETFs) and over-the-counter funds based on purchasing channels.

Exchange-traded funds are relatively easier to trade. We can redeem funds at the bank counter we frequently visit or operate online. Many platforms like Tian Tian Fund, Taobao, and JD.com have numerous funds available for redemption. The funds redeemed from different websites are the same, just different channels, so we should choose those with lower fees and better services.

However, this book primarily recommends exchange-traded funds, commonly known as ETF index funds.

ETF index funds require a stock account to purchase, which is slightly more complicated but absolutely worth it:
First, the trading fees for ETFs are close to those of stocks, generally below 0.05% (this varies slightly among different brokers, with larger brokers like Huatai and Guojin generally having lower fees), while buying funds outside the exchange can incur fees of up to 0.1%. In terms of management fees, ETFs also charge lower fees than off-exchange funds.

Second, the time for buying and selling is shorter. Friends who have redeemed stock funds at banks or websites know that cash from redeeming stock funds takes a long time to arrive, usually requiring 5 working days, while some efficient funds can do it in 3 working days. In contrast, ETFs have the same cash arrival time as stocks; they can be sold on the same day and cash can be withdrawn the next working day, making it more convenient and faster.

Third, ETFs generally have better long-term returns, making it worthwhile to go through the trouble of opening a stock account. Moreover, opening a stock account is currently free, and basic knowledge on how to open an account and purchase ETFs can be found online or by consulting securities company customer service, so I will not elaborate further.

Chapter 2: Understanding Indexes#

In the previous chapter, we introduced the classification of funds. Among them, one type of fund is the index fund, which is the only type that stock god Buffett has repeatedly introduced in public. This is also the investment variety that this book focuses on. Starting from this chapter, we will introduce knowledge related to index funds.

2.1 What is an Index?#

What is an index?
An index is actually quite simple; it is a weighted average used to reflect the average level of the market.
We often encounter indexes in daily life. For example, the average score of a class or the average age of a city. This average value can reflect the average level of a certain aspect, which is the role of an index.

With thousands of stocks in the stock market, how do we calculate the average price of a certain type of stock? To answer this question, stock indexes were born. For example, the well-known CSI 300 Index is composed of 300 of the largest and most liquid stocks selected from the Shanghai and Shenzhen stock exchanges. The 300 constituent stocks of the CSI 300 Index are re-selected twice a year. The stock prices of these 300 stocks are weighted according to their respective proportions to calculate what we commonly refer to as the CSI 300 Index.

2.2 Who Developed Stock Indexes?#

Indexes did not arise out of thin air; there are two types of institutions that develop indexes: stock exchanges and index companies.
There are three major index series in China. The Shanghai Stock Exchange develops the Shanghai series of indexes, and the Shenzhen Stock Exchange develops the Shenzhen series of indexes, both of which belong to exchange-developed indexes. The China Securities Index Company develops the CSI series of indexes, which belong to index company-developed indexes.
For example, the Shanghai Composite Index is developed by the Shanghai Stock Exchange.

In the U.S., there are three major indexes: the Nasdaq Index, the S&P 500 Index, and the Dow Jones Index. The Nasdaq Index is an exchange index, while the S&P 500 and Dow Jones indexes are developed by index companies.
In Hong Kong, the main index is developed by the Hang Seng Company, such as the Hang Seng Index and H-share Index.
Additionally, there are some world-renowned index development companies, such as Morgan Stanley, which develops the MSCI series of indexes.

2.3 Why Do Wealthy People Prefer Index Funds?#

Why does the cautious Buffett recommend index funds to ordinary investors in public? This depends on some characteristics of indexes: average, perpetuity, passivity, cyclicality, and low risk.

The role of an index is to show the weighted average of a group.
If there are 10 classes in a grade, each with 50 students, how do we compare the academic performance between different classes? It’s simple; we calculate an average score for each class and compare these averages.
This is the role of an index, to seek a weighted average to show the average value. The roles of different indexes are similar; the difference lies in the different constituent stocks determined by their rules and the different weights measured during weighting.
Also, due to the law of large numbers, theoretically, the larger the sample space of an index, the more effective the index is.
An index is a rule that possesses perpetuity, passivity, and cyclicality.
The existence of rules provides perpetuity. The rules of the SSE 50 have perpetuity; give it a sample of A-shares, and it can calculate; give it a sample of U.S. stocks, and it can still calculate. As long as the rules are established, it can be executed passively.
At the same time, due to the existence of perpetuity, the index will continue to fluctuate during its existence. It can be likened to Schumpeter's "four-stage" cycle theory. The index will oscillate between undervaluation and overvaluation. So there is no need to worry about missing out on undervalued buying opportunities or overvalued selling opportunities.
An index possesses the general characteristics of its constituent members while avoiding many individual stock risks.
A stock index can be seen as an individual stock that possesses an average level and is immortal. It inherently possesses all the characteristics of individual stocks, including profits, liabilities, assets, sales revenue, and so on. We can analyze the index using individual stock strategies.
We also know that individual stocks have many unpredictable risks, such as falsifying accounts, long-term suspension of trading, dilution of existing shareholders' earnings due to additional issuance, and unforeseen black swan events in management. Index funds can help us avoid these risks.
From these characteristics, we can see the benefits of indexes.
Tracking an index allows us to obtain the average value of the market; the passivity of the index allows us to eliminate human fears and greed; the perpetuity of the index greatly reduces the possibility of permanent loss of principal; the cyclicality of the index provides us with a continuous stream of buying and selling opportunities; the index possesses the characteristics of individual stocks, allowing us to analyze it using value investment strategies while avoiding some risks.
It is precisely because of these advantages that stock god Buffett recommends index funds to ordinary investors in public. The cautious Buffett recognized these benefits of index funds before recommending them to everyone.

Of course, from the definition of an index, we can also see its main disadvantage: it can only achieve market averages. It is difficult to rely on index funds to become rich overnight. However, considering that the proportion of investors who can outperform the index over 10 years is less than 5%, investing in index funds is still acceptable for investors lacking a circle of competence.

Chapter 3: Understanding Index Funds#

3.1 What is an Index Fund?
As mentioned earlier, a fund is a basket of assets. A stock index is a basket of stocks selected according to certain rules. If a fund company develops a product that buys a basket of stocks according to the index's constituent stock ratios, it can replicate the index's performance, which is an index fund.
For example, there are more than 7 ETF funds tracking the CSI 300 Index. These 7 funds all track the CSI 300 Index, but they are products developed by different fund companies.
3.2 The Error of Index Funds
An index is a mathematical formula, but turning it into a tradable financial product still involves errors, so index funds need to be carefully selected.
From the stock market crash and liquidity crisis in 2015, it can be seen that different companies have very different experiences in dealing with large redemptions. The top 10 fund companies outperform small fund companies in both strength and experience. Therefore, when purchasing index funds, one should first choose index funds from large fund companies that have been operating for a long time.
Although ETFs have many advantages, we must also pay attention to some hidden risks, such as the fund not being fully invested, leading to significant tracking errors; cross-border index funds carrying exchange rate risks without hedging, etc. When operating these funds, we need to leave a larger safety margin. For example, the H-share ETF has more than 10% cash that is not invested and also carries exchange rate risks, so when investing in it, we need to reserve a larger safety margin.
Thus, when investing in index funds, we must consider these possible errors and risks.
Error 1: The performance benchmark of index funds—some index funds do not have their corresponding index as their performance benchmark.
Error 2: The position of index funds—tracking errors caused by not being fully invested.
Error 3: Management fees caused by different channels of index funds—generally, on-exchange funds have lower fees than off-exchange funds, leading to smaller errors.
Error 4: Exchange rate risks—exchange rate risks of cross-border index funds.
Error 5: The scale and operational history of index funds—the larger the scale and the longer the operational history, the better the performance of index funds belonging to large companies in dealing with liquidity crises or large redemptions. It is advisable to avoid funds that have been listed for less than a year or those with a long delay in building positions.

Of course, this does not mean that index funds will lag behind the tracked index in long-term performance. In fact, the vast majority of long-running index funds have long-term returns higher than the index returns. This is because indexes generally do not consider the dividends of constituent stocks, while index funds accumulate received dividends and distribute them in cash periodically. Especially for some high-dividend index funds, the gap between them and the index will widen under the effect of long-term compounding.

3.3 Broad-Based Index Funds: The Most Stable Index Funds#

So, what kind of index funds are worth buying?
Here, I recommend broad-based index funds. Not all indexes qualify to be established as index funds. Generally, well-designed and influential broad-based indexes are more likely to be developed into index funds.
"If an index includes more than 10 stocks, with no single constituent stock exceeding 30% weight, and the cumulative weight of the top 5 stocks not exceeding 60% of the index, and the average daily trading volume of the constituent stocks exceeding 50 million USD, then this index can be called a broad-based index." This is the definition of a broad-based index by the American Securities and Futures Exchange.
However, when defining broad-based indexes here, I also want to add another definition: the included industries should be diverse.
The CSI 300 includes 300 stocks, covering various industries. Compared to a financial index that focuses solely on the financial sector, it is more stable. If economic downturns occur, the financial index will be dragged down by banks, but the banking proportion in the CSI 300 is lower than that in the financial index, making the profitability of the CSI 300 more stable.

This is the greatest advantage of broad-based indexes: they include various industries, making profitability much more stable than that of a single constituent stock. The more constituent stocks there are and the more industries covered, the more evenly distributed the broad-based index's profitability will be.
In contrast, industry indexes categorize stocks based on different industries, divided into primary and secondary industries. What are primary and secondary industries?
For example, energy is a primary industry; the oil industry falls under the energy sector as a secondary industry, and oil extraction is further subdivided into a tertiary industry. The industry is subdivided to the extreme, down to individual stocks.
Industry indexes carry more characteristics of their respective industries, and their analysis methods differ from those of broad-based indexes. Most of the index funds analyzed in this book are primarily based on broad-based index funds that include various industries, such as the CSI 300, SSE 50, Hang Seng Index, S&P 500, and Nasdaq.

Chapter 4: Valuation of Index Funds#

4.1 What is Valuation?
Assets can be viewed from many different angles. For example, from the price perspective, each asset can have a market price indicating its current market trading price.
Valuation is the process of assessing an asset from various angles. For example, from the perspective of asset profitability, from the perspective of asset value, etc. Since we mainly invest in stock index funds, we need to understand common stock valuations.
In the early days, stocks had no valuation; people simply negotiated prices to buy and sell stocks. Later, as research on stocks deepened, various valuations began to emerge to assist in investment. The three most common valuations are price-to-earnings ratio (PE), price-to-book ratio (PB), and dividend yield.
These valuation indicators have been used by countless investment masters for decades. They each have their applicable scope and limitations. Familiarizing ourselves with their advantages and limitations will help us use them better.

4.2 Measuring Profitability Premium: Price-to-Earnings Ratio
The definition of the price-to-earnings ratio is: company market value / company earnings (i.e., PE = P/E, where P represents company market value and E represents company earnings).
Depending on the earnings used, it can be divided into static PE, dynamic PE, and rolling PE. Among these, static PE uses the previous year's net profit, dynamic PE uses the estimated net profit for the next year, and rolling PE uses the net profit from the most recent four quarterly reports. The most meaningful reference is static PE, which is what we usually refer to as the PE ratio.
Information Behind the Price-to-Earnings Ratio

The price-to-earnings ratio reflects how much we are willing to pay for one yuan of net profit.
For example, if a company's PE ratio is 10, it means we are willing to pay 10 yuan for 1 yuan of profit from this company.
Estimating Market Value
If a company earns 10 billion yuan in net profit and has a PE ratio of 10, its market value would be 100 billion yuan. Market value represents the theoretical amount of funds needed to buy this company. Very few companies' earnings fluctuate significantly within a year, but their market values can rise sharply in a bull market and fall sharply in a bear market, due to the significant fluctuations in PE valuations: bull markets push up the valuation of unit earnings.

The applicable scope of the price-to-earnings ratio: good liquidity and stable earnings.
The price-to-earnings ratio includes two variables: market price and earnings. Therefore, the prerequisites for applying the price-to-earnings ratio are twofold: first, good liquidity that allows for market price transactions; second, stable earnings that do not fluctuate significantly.

Good Liquidity
This is a crucial yet often overlooked factor.
In the past, I often saw people saying that "god stocks" like Quanta Education had PE ratios exceeding 100. In fact, such highly speculative stocks have lost their reference value for the PE ratio. Because these stocks have poor liquidity, buying and selling them requires very little capital, leading to explosive price fluctuations.

The poorer the liquidity of a stock, the less reference value the PE ratio has. This is because when you want to invest based on this PE ratio, your investment behavior will greatly affect the market price, creating a feedback effect.
For example, there are many stocks in the Hong Kong market with daily trading volumes of less than a thousand, and their PE ratios may even be below 0.1. From a valuation perspective, they seem incredibly undervalued. However, when you try to invest, you may find that to buy this stock, you have to offer much more than the last transaction price. The worse the liquidity, the more pronounced this phenomenon becomes.

Many small stocks in the A-share market exhibit similar effects, where a few tens of thousands can push a stock to its daily limit up or limit down. During the recent stock market crash, many people wanted to sell but couldn't. In such cases, valuation indicators have little reference value.

Having relatively reasonable liquidity is a prerequisite for applying all valuation indicators. Generally, stocks that can enter indexes like the CSI 300 or the CSI 500 have no liquidity issues.

Stable Earnings
This is the second prerequisite for using the price-to-earnings ratio. Some industries do not have stable earnings and are not suitable for the price-to-earnings ratio, such as declining industries with "price-to-earnings traps" and cyclical industries. Some industries are in a growth phase or are losing money, making them unsuitable for the price-to-earnings ratio.

Low Price-to-Earnings Ratio Traps
Industries with price-to-earnings traps are mostly declining and cyclical industries.
Some industries may have very low price-to-earnings ratios, but in reality, the industry may have entered a downward cycle, with profits continuously decreasing. From the perspective of PE = P/E, as E decreases, PE will gradually increase, no longer being undervalued. This is the "price-to-earnings trap."

Cyclical industries also do not suit the price-to-earnings ratio. For example, in the securities industry, profits can surge several times during bull markets, and the original PE ratio of 40-60 can suddenly drop to single digits. From a price-to-earnings perspective, it may seem undervalued, but in reality, this is only temporary. Once the economic cycle passes, industry profits will plummet, and the price-to-earnings ratio will rise from single digits back to dozens.

Many cyclical industries exist, such as steel, coal, securities, aviation, and shipping. Industries that provide homogeneous products and services exhibit significant cyclicality and are not suitable for price-to-earnings ratio valuation.

Growth Stocks and Loss-Making Stocks
Clearly, loss-making stocks cannot use the price-to-earnings ratio as an indicator. Additionally, stocks in a high-growth phase often need to reinvest most of their profits to expand, so earnings may be artificially adjusted and not stable, making them unsuitable for price-to-earnings ratio valuation.

Stocks with good liquidity and stable earnings can use the price-to-earnings ratio for valuation. Most broad-based index funds meet these two criteria well, so using the price-to-earnings ratio to value broad-based index funds is feasible.

4.3 Measuring Net Asset Premium: Price-to-Book Ratio
The price-to-book ratio refers to the ratio of the stock price to the net asset value per share, which is what we refer to as book value.

Net assets, simply put, are assets minus liabilities, representing the equity shared by all shareholders. The specific calculation can be found in the annual reports of listed companies. This financial metric is generally more stable than earnings. Moreover, most companies' net assets tend to increase steadily, allowing for the calculation of the price-to-book ratio.

Factors Affecting the Price-to-Book Ratio

The efficiency of a company's operating assets: ROE
When discussing the price-to-book ratio, we must mention return on equity (ROE). ROE is the return on equity, calculated as net profit divided by net assets.
For a company, assets are the materials for its operations; it needs to generate returns from operating those assets for them to have value. Otherwise, the asset is of no use. With the same assets, some companies can operate them to generate higher returns, indicating higher asset operating efficiency. The key indicator for measuring asset operating efficiency is return on equity (ROE).
I personally believe that ROE is the most critical operational indicator for a company. Buffett's long-time partner, Charlie Munger, has also stated: "In the long run, a stock's return is closely related to the company's development. If a company has maintained a profit of 6% on capital (i.e., ROE of 6%) for 40 years, then 40 years later, your average return will not differ much from 6%, even if you initially bought it at a low price. If the company's profits are 18% on capital for 20-30 years, even if you initially paid a high price, the return will still satisfy you."

The higher the ROE of a company, the higher the asset operating efficiency, and the higher the price-to-book ratio.

Stability of Asset Value
Assets come in various forms; some can appreciate over time, while others may depreciate rapidly.
For example, Moutai, the white liquor being brewed, will appreciate over time; however, computer chips produced by Intel will rapidly depreciate if not sold promptly.

The more stable the asset value, the more effective the price-to-book ratio will be.

Intangible Assets
Traditional companies have a large portion of their net assets in tangible assets, such as land, mines, factories, and raw materials. Their values are relatively easy to measure. However, many assets are intangible and difficult to measure, such as corporate brands, senior technical engineers, patents, and the influence of the company's channels and industry voice.

If a company primarily relies on intangible assets for operation, like law firms, advertising service companies, or internet companies, the price-to-book ratio will have little reference value.

Significant Increase in Liabilities or Losses
Net assets are the company's assets minus liabilities. If a company's liabilities are unstable, it may interfere with net assets. Additionally, if a company incurs losses, it may erode more assets, leading to a decrease in net assets.

From this, we can see that a company's assets are generally relatively easy to measure in value and are long-term preserved assets, such as factories, land, railways, and inventory. Such companies are very suitable for price-to-book ratio valuation. If cyclical stocks primarily consist of tangible assets and those assets maintain long-term value, then those cyclical stocks are very suitable for price-to-book ratio valuation. Industries such as securities, aviation, shipping, and energy are all suitable for price-to-book ratio valuation. Therefore, some cyclical industry index funds are suitable for price-to-book ratio valuation; if broad-based index funds encounter short-term economic crises and unstable earnings, the price-to-book ratio can also assist in valuation.

4.4 Cash in Hand: Dividend Yield
Dividends are the best way for investors to share in a company's performance growth without reducing their equity stake.

What is the difference between dividend yield and payout ratio?
Dividend yield and payout ratio are similar concepts but are actually different.
Simply put, dividend yield is the total cash dividends paid by a company over the past year divided by the company's total market value. The payout ratio is the total cash dividends paid by a company over the past year divided by the company's total net profit. These two ratios have the same numerator, but one denominator is the company's market value, while the other is the company's net profit for that year. (Of course, there are some differences in details, such as taxes on dividends, etc., but this is the general understanding.)

The payout ratio is generally set in advance by the company and remains unchanged for many years. For example, Industrial and Commercial Bank of China has a payout ratio of around 50%, meaning it will distribute 50% of its net profit in cash dividends over the past year. In contrast, dividend yield fluctuates with stock prices: the lower the stock price, the higher the dividend yield.

What is the use of dividends?
As ordinary secondary market shareholders, we do not enjoy many rights.

Buffett can use large sums of money to buy entire companies, such as when he bought See's Candies for 25 million, which had a net profit of 2.08 million that year. As the actual controller of the company, Buffett can freely decide whether to reinvest this 2.08 million or spend it. However, ordinary investors cannot intervene in the company's net profit.

Even if a company's net profit grows rapidly, if the stock price does not rise in the secondary market, retail investors still cannot enjoy the benefits of the company's performance increase. A typical example is Industrial and Commercial Bank of China, whose net profit has surged from 2007 to now, but the stock price has hardly increased.

However, dividends can translate the company's performance growth into cash returns for investors.

If the goal is to obtain dividends, holding shares of Industrial and Commercial Bank of China, the dividend per share has risen from 0.16 yuan in 2007 to 2.55 yuan this year. The dividend yield has increased significantly, in line with performance growth.

You do not need to sell your equity stake to receive continuously growing cash flow. In fact, this is also the way the state shares the profits of state-owned listed companies: for domestic listed banks, the major shareholders are mostly the Central Huijin Investment Company, the Ministry of Finance, and the National Development and Reform Commission, which must ensure state control over listed banks, and their stocks are rarely sold. In this case, the way to enjoy profits is to increase the company's dividend payout ratio, thus obtaining high dividends each year.

Dividends are a good way to hold equity assets long-term while enjoying cash flow returns. By holding a portfolio of high-dividend stocks for a long time, you can achieve financial freedom easily without worrying about stock price fluctuations, receiving steadily increasing cash dividends each year.

4.5 How to Check the Valuation of Index Funds?
We have learned the basic valuation methods for stocks. Are these valuation methods useful for investing in stock funds?
Of course, they are useful. Stock funds consist of a basket of stocks, and essentially, stock funds are a special type of stock. Therefore, stock valuation methods also apply to stock funds. However, since stock funds include dozens to hundreds of stocks, calculating the valuation of a stock fund on your own is very cumbersome, so most stock funds do not calculate valuations.

Fortunately, as mentioned earlier, the goal of index funds is to replicate the index, and indexes are developed by exchanges or index companies. Exchanges and index companies publish the valuations of indexes, which can essentially be considered as the valuations of index funds. These valuations can be found on their official websites. Here is a brief explanation of how to find them.

Method 1: Follow me on Xueqiu
I know that finding index valuations is not easy, so I have compiled the valuations of various indexes. Every evening, I will publish the PE and PB valuations of index funds after the market closes. In the future, I will also add the valuations of major global indexes for easier access.
You can directly follow me on Xueqiu: search for "Bank Screw" and follow me.

When you read this book, some time may have passed since I wrote it, and the methods introduced may have changed. You can also ask me directly on Xueqiu, and I will answer all questions!

The following is an example of the valuation situation I published.

Method 2: China Securities Index Official Website
The SSE Index, SSE 180, SSE 50, SSE 380, CSI 300, Shenzhen Component Index, Shenzhen 100R, ChiNext Index, Dividend Index, and CSI Dividend can all be checked for their PE and PB ratios on the China Securities Index official website, which is updated daily.
Website:
http://www.csindex.com.cn/sseportal/csiportal/zs/jbxx/daily_index_info.jsp.
Method 3: Shenwan Historical Data
Download through this website:
http://www.swsindex.com/idx0510.aspx.
You can use Excel or MATLAB to do some simple historical data analysis.

Chapter 5: Currently Tracked Index Funds#

Although the index funds in the A-share market have not developed as well as in mature markets, there are already hundreds of various index funds available, making selection quite labor-intensive. Here, I will introduce a few index funds that I am currently tracking and that are suitable for beginners. Considering the advantages of lower fees, I will introduce ETF index funds here.

Due to space limitations, I will only list a few index funds that are currently undervalued or close to undervalued. In the future, I will write more analysis articles on index funds, and interested friends can follow my Xueqiu homepage.

5.1 H-share Index
This is the Hang Seng Index Company's Hang Seng State-Owned Enterprises Index. It tracks the Hang Seng H-share Index, mainly consisting of large state-owned enterprises listed in Hong Kong, with its main constituent stocks being similar to those of the SSE 50, essentially serving as a benchmark.

The H-share Index currently has the lowest valuation among all broad-based indexes, with a PE ratio of only over 8 times, making it the lowest valuation globally, except for Russia and Brazil, which are in a similar situation. Not only is the valuation low, but its historical profitability is also higher than that of the S&P 500 Index during the same period, making it a good index.

People often say that the Hong Kong stock market has poor liquidity and is becoming increasingly marginalized, making it a bad investment market. However, over the past decade, holding undervalued H-shares has yielded significantly higher returns than A-shares. Just like the previously undervalued B-shares, which also provided much higher returns than A-shares. The value of a stock is equal to the discounted cash flow it can generate over its remaining life. Based on this, the higher the discount, the better the returns.

Backtesting the historical data of the Hong Kong stock market over the past 30 years, buying below a 10 PE and holding for over 9 years has a high probability of yielding over 6 times returns. If the valuation is even lower, the return rate will be higher. Currently, the valuation of the H-share Index is not at its historical lowest, but it undoubtedly falls within the category of absolute undervaluation, making it a good choice for regular investment.

The largest and most liquid ETF tracking H-shares is the E Fund H-share ETF (510900).

5.2 SSE 50 Index
The SSE 50 Index is a standard blue-chip index, representing the blue-chip stocks among blue-chips. It consists of 50 stocks with large market capitalization and good liquidity from the Shanghai stock market, weighted primarily by market capitalization.

As one of the three major indexes in A-shares, the CSI 300 represents blue-chips, the CSI 500 represents small and medium stocks, and the SSE 50 represents super large blue-chips. Among these three, the SSE 50 has the lowest valuation but the highest ROE (mainly due to bank stocks).

In fact, attentive readers will notice that the SSE 50 and H-share Index have a good relationship, as there is a significant overlap in their constituent stocks. We can look at the top ten holdings of these two indexes:
SSE 50:

H-share Index:

The constituent stocks in these two indexes are mostly well-known stocks in the market. This means that the fundamentals of these two indexes are similar, so theoretically, the one with the lower valuation has more investment value. The standard for valuation is the price-to-earnings ratio.

In the past, some friends asked me whether the H-share Index seemed to underperform compared to A-shares, as it appeared to have poor returns.

Is this really the case?#

The SSE 50 was established in early 2004, starting from 1,000 points, and by the close on November 25, 2015, the index was at 2,459 points, an increase of 145.9%.
During the same period, the H-share Index rose from 3,832 points to today's 10,127 points, an increase of 164.2%, significantly outperforming the SSE 50 Index.

Moreover, this is the increase in the index, not including dividends. If dividends are considered, the SSE 50's closing points on the 25th would be 3,120 points, yielding an annualized return of 10.8%; while the H-share Index, considering dividends, would have a closing point of 17,441, yielding an annualized return of 14.5%, far exceeding the SSE 50's annualized return!

From a long-term return perspective, the SSE 50 has significantly lagged behind the H-share Index, primarily because the H-share Index has more undervaluation opportunities: historically, the H-share Index has been undervalued compared to the SSE 50 for most of the time, with only a brief period of premium during the major bear market of 2013-2014.

The above examples are a retrospective of the past and do not represent the future; perhaps the SSE 50 will have a lower valuation in the future, as seen in 2013-2014. However, we can conclude that when the fundamentals of two similar indexes are close, buying the one with the lower valuation will yield better returns.

Currently, there are many index funds tracking the SSE 50 Index; here I recommend the largest one, the Huaxia SSE 50 ETF (510050), which is also the first ETF tracking the SSE 50, with good scale, liquidity, and minimal tracking errors.

5.3 Hang Seng Index
I often see friends confuse the Hang Seng Index with the H-share Index. Although both indexes are published by the Hang Seng Company and have some overlap in constituent stocks, they are different indexes.

The Hang Seng Index represents the blue-chip stocks in the Hong Kong stock market, selected from all listed companies on the Hong Kong Stock Exchange, consisting of the 50 largest and most liquid companies, reflecting the overall level of the Hong Kong stock market, with the maximum proportion of a single constituent stock being 15%; it is also a trading index, around which a series of financial derivatives have been established, so the Hang Seng Index pays great attention to liquidity. In this regard, the Hang Seng Index's positioning is somewhat similar to the CSI 300, but it has fewer constituent stocks than the CSI 300.

The Hang Seng Index is also the oldest among the indexes that are most closely related to A-shares. The Hang Seng Index was born on November 24, 1969 (though the base date for the index is July 31, 1964, with a base index of 100 points).

The Hang Seng Index is a classic and excellent index. It has stable returns, reasonable valuation distribution, and a much higher average dividend yield than A-shares.

As of the close on November 19, 2015, the Hang Seng Index was at 22,500 points, with an annualized return of 11.2%. This return may not seem high, but this point does not consider dividends. If dividends and total returns are taken into account, the total return index of the Hang Seng Index is 55,439 points, with an annualized return of 13.2%. Considering that the Hang Seng Index had a relatively high valuation at its inception, this return can be considered quite good. This is also the advantage of the Hang Seng Index, which has achieved an average annual return of 13.2% over 40 years.

As a mature trading market, the valuation distribution of the Hong Kong stock market is also relatively reasonable. The Hong Kong Stock Exchange is closely related to A-shares, and its system is also very complete. High-dividend, high-liquidity, stable profit, and stable ROE blue-chip stocks can command higher premiums, while low-dividend, unstable profit small-cap stocks are mostly discounted. This is the biggest difference in valuation distribution between A-shares and Hong Kong stocks.

(PS: "Old thousand stocks" are a characteristic of the Hong Kong stock market. Just based on indicators like price-to-earnings ratio and price-to-book ratio, there are many stocks in Hong Kong with very low valuations, even some with PE ratios below 0.1. However, many of these are "old thousand stocks," which may appear undervalued and seem like a bargain, but regardless of how much investors invest, the result may be a continuously declining market value until it approaches zero. The basic characteristics of such stocks include frequent related-party transactions, almost no dividends, and frequent financing, either through issuing shares or convertible bonds. This also shows that relying solely on valuation indicators for individual stocks is not effective.)

The Hong Kong stock market is primarily dominated by institutional investors. The existence of "old thousand stocks" has gradually driven retail investors out of the market. Stable returns and high-dividend blue-chip stocks are the favorites of institutions in the Hong Kong stock market. This is also reflected in the Hang Seng Index: the current dividend yield of the Hang Seng Index is around 4%, compared to the current dividend yield of the CSI 300 at 2.05%, showing a clear advantage.

As mentioned earlier, the total return index of the Hang Seng Index, considering dividends, is more than double that of the total return without dividends, with dividend income contributing significantly to long-term investment returns. This aligns with Professor Siegel's conclusion that "the main source of returns from long-term stock investments is dividend income."

Of course, the Hang Seng Index also has its drawbacks; half of its constituent stocks are in the financial sector, which is not lower than that of the CSI 300. If you are concerned about bad debts in mainland banks, the Hang Seng Index may not be a good choice. However, the valuations of bank stocks in Hong Kong are already lower than those in A-shares, providing a higher safety margin, reflecting bad expectations.

Next, let's discuss the valuation and investment value of the Hang Seng Index.
The following chart shows the PE ratio curve of the Hang Seng Index since 1973, along with the frequency distribution of different PE ratios.

From the chart, we can see:

(1) The Hang Seng Index's valuation has mostly appeared around the average valuation of 14.46 times.
(2) For 68% of the time, the Hang Seng Index's valuation has been around 14.46 times, which is the normal valuation range for the Hang Seng Index, between 11 and 18 times PE.
(3) For 16% of the time, the Hang Seng Index's valuation has been below 11 times, which is the undervalued area; for 16% of the time, it has been above 18 times, which is the overvalued area.
(4) The Hang Seng Index is considered overvalued above 18 times, but the range of overvaluation is significantly wider than that of undervaluation. In other words, the risk of shorting is much greater than that of going long.
(5) The lower or higher the valuation, the probability of occurrence decreases geometrically. Therefore, it is best not to pin hopes on buying at the lowest or selling at the highest. Entering undervalued areas should involve buying in batches, while entering overvalued areas should involve selling in batches, which is a more realistic approach.

Currently, the PE ratio of the Hang Seng Index is around 9.1, clearly in the undervalued area. From a long-term investment perspective, the current Hang Seng Index is a very good choice, with a high probability of returning to above the median valuation.

There are several ETFs tracking the Hang Seng Index; here I recommend the Huaxia Hang Seng ETF (159920), which is established through the Shanghai-Hong Kong Stock Connect. Huaxia Company has considerable experience in reducing ETF errors, and as an established fund company, it has more experience in fund operations.

5.4 Dividend Index#

The three indexes introduced above are all market capitalization-weighted indexes. Here, I will introduce a strategy-weighted index: the Dividend Index.

Generally speaking, strategy-weighted indexes can often outperform similarly positioned market capitalization-weighted index funds. The strategy used by the Dividend Index is the high-dividend strategy. It selects the 50 stocks with the highest cash dividends and largest market capitalization from the Shanghai Stock Exchange over the past two years, focusing on liquidity. Generally, high-dividend stocks in A-shares are mostly blue-chip stocks in mature industries, so the Dividend Index can be seen as a blue-chip stock index. The ETF tracking the Dividend Index is the Dividend ETF (510880), which is also the fund I have invested in the longest.

Those familiar with individual stock investments are no strangers to stock dividends. Some may ask, why bother with dividends when they need to be adjusted for rights issues?

Dividends allow investors to directly enjoy the company's performance growth and enable them to receive cash returns without reducing their ownership in the company. If you want to achieve financial freedom through the stock market, having a portfolio of high-dividend stocks that provides gradually increasing cash dividends each year is the best choice.

Moreover, there is sufficient evidence to suggest that high-dividend stocks tend to have higher long-term returns. In "The Long-Term Secrets to Investing in the Stock Market," Siegel backtested data from the S&P 500 from 1871 to 2012 and found that dividends were the most important source of shareholder returns during that entire period. Since 1871, the actual return on stocks has been 6.48%, with dividend income contributing 4.4% and capital gains yielding 1.99%.

What I mentioned above pertains to stock dividends; what about fund dividends?
The index we usually refer to does not include dividends. On the official website of the SSE Index, you can see that indexes generally also have a total return index, which considers the returns after dividends. Taking the Dividend Index as an example, the current index is 3,170 points, while its total return index is 4,404 points, with the additional amount being due to dividends.

The following chart shows the annual dividend records of the Dividend ETF:

Index funds strictly track indexes, so cash dividends will affect the fund's tracking. The fund will accumulate stock dividends and distribute them in cash after a while. The Dividend ETF performs well in this regard, basically achieving annual cash dividends.

Chapter 6: How to Invest in Index Funds?#

Although index funds have many advantages, not all investments in index funds will yield profits.
If we had invested in the CSI 300 during the bull market in 2007, we might still be stuck today. Therefore, it is also necessary to have the right strategy when investing in index funds.
All investment strategies essentially address the questions of "what to buy, how to buy; what to sell, how to sell." In this chapter, we will introduce "what to buy" and "what to sell."

6.1 The Biggest Advantage of Index Funds: Perpetuity
We have previously discussed the benefits of indexes, which possess some very high-quality characteristics that individual stocks do not have. The most important characteristic is perpetuity.
Taking the U.S. stock market as an example, we know that its history is much longer than that of A-shares. There is a famous index in the U.S. called the Dow Jones Index. Established in 1884, the Dow Jones Index was composed of the 12 most influential stocks in the U.S. at the time, starting with just over 40 points. Over the following century, the Dow Jones Index experienced the first and second world wars, the oil crisis, and the financial crisis, gradually rising from over 40 points to over 17,000 points, an increase of over 400 times.

However, we need to note that of the original 12 constituent stocks, only one, General Electric, remains today.
In other words, if we had bought any of those 12 stocks back then, none would exist today.

From this, we can see the biggest advantage of indexes compared to individual stocks: we call this advantage perpetuity. Every company dreams of perpetual operation, but in reality, very few companies survive for fifty or sixty years. Indexes can easily achieve this time span.
As long as the stock market exists, you will never have to worry about index funds going bankrupt or being falsified. Therefore, if we want to build a long-term investment plan for our lives that lasts for decades, index funds are an excellent choice.

6.2 Why Doesn't Buying Index Funds Always Yield Profits?#

Since index funds can exist perpetually, does that mean we can buy and sell index funds at will and still make money?
Of course not.
Let’s take a common example. Suppose we invested 20,000 yuan in the CSI 300 index fund last July, and by May of this year, our initial investment of 20,000 yuan has turned into 40,000 yuan.
Typically, retail investors would take advantage of this and invest more money in the same fund. If they buy another 100,000 yuan, they will find that they have not made a single cent and have instead lost over 10,000 yuan.

Many people would be confused as to why the same fund can yield profits on the first purchase but result in losses on the second purchase.
The reason is simple: the second purchase was made at a higher price.
Buying stocks is similar to buying houses or groceries. If a vegetable is worth 4 yuan, and you pay 8 yuan for it, you have overpaid; if a house is worth 1 million, and you pay 2 million for it, you have overpaid. If you buy stocks at a high price, it will be difficult to make a profit later.

Therefore, we should buy stocks when they are cheap, not when they are expensive.
So how do we know if a stock is cheap or expensive? This requires us to master a valuation method to help us make judgments.

6.3 Graham's Valuation Method: Earnings Yield
Almost every investment master has their own preferred valuation method; we do not need to master all methods, just learning one simple and effective method is enough.
Here, I will introduce a simple and effective method I am currently using, which comes from Graham.
Graham is a famous value investing master, author of "Security Analysis" and "The Intelligent Investor," and is considered the founder of modern finance, as well as being Buffett's teacher. Buffett even named his eldest son "Howard Graham Buffett" to commemorate his teacher.

In Graham's later years, he pondered how to quickly and effectively value stocks. He used an indicator called earnings yield.

What is earnings yield? The definition of earnings yield is:
Earnings Yield = Stock Earnings / Stock Market Value.

For example, if a stock's earnings per share is 1 yuan and the current stock price is 8 yuan, then the earnings yield for this stock is 1/8, or 12.5%.

Does this definition of earnings yield sound familiar?
Yes, earnings yield is the reciprocal of the price-to-earnings ratio. The price-to-earnings ratio is price divided by earnings, while earnings yield is earnings divided by price, being reciprocals of each other. In fact, earnings yield is just another way of expressing the price-to-earnings ratio.

This expression of earnings yield allows us to easily compare index funds with bond yields, other index funds' earnings yields, real estate rental ratios, bank wealth management annual yields, and so on, thus selecting the most worthwhile investment category.
In simple terms, earnings yield allows us to view stocks as a special type of bond, with the earnings yield representing the interest rate of this bond.

6.4 Two Indicators to Buy the Right Index Funds#

By observing the historical data of stock markets in various countries, we find that in most markets, when the bear market is at its lowest valuation, the price-to-earnings ratio is usually below 10, meaning the earnings yield is above 10%. Graham used this earnings yield as the first standard for buying stocks.
For example, looking at the historical trends of the Hang Seng Index's price-to-earnings ratio, we can see that the price-to-earnings ratio has been below 10 at various times.

So what is the second standard? Graham believed that we should only consider stocks when the earnings yield is more than twice the yield of government bonds.
This is Graham's two standards for buying stocks, which are very simple:

(1) The earnings yield must be greater than 10%;
(2) The earnings yield must be more than twice the yield of government bonds.
Index funds that meet these two requirements can be included in our buying candidates.

Let’s recall the situation when we bought funds in May of this year.
In May of this year, the price-to-earnings ratio of the CSI 300 was around 20 times, translating to an earnings yield of only 5%, far below twice the yield of government bonds. According to Graham's standards, we should not have bought the CSI 300 index fund at that time.

6.5 When to Sell for Profit?#

When it comes to profiting from funds, when should we sell? This question has always been one of the biggest dilemmas for all investors. In fact, there is no universal rule for selling strategies; different investment masters have different strategies.
For example, Buffett generally does not sell; he holds onto companies that continuously provide cash flow until their fundamentals deteriorate or they become excessively overvalued. Peter Lynch is more active in buying and selling; he uses the money from sales to buy new shares. John Neff believes that buying is for selling; he sells stocks at appropriate valuations.

My selling strategy mainly references Graham's thinking. This strategy may not apply to all varieties, but it is relatively suitable for current index funds.

Earnings yield: measuring the relative investment value of stocks.
We have already understood the definition of earnings yield and how to use it to buy stocks.
Graham often uses earnings yield to measure the value of stocks. He views stocks as a special type of bond, with the interest rate of this bond being the earnings yield. We previously mentioned that indexes have perpetuity; as long as the stock market exists, stock indexes will exist. Therefore, index funds can be approximated as a special type of perpetual bond, with fluctuating face values and interest rates, where the current interest rate is the earnings yield.

Earnings yield can also be influenced by two factors: short-term stock price fluctuations and long-term growth. The lower the stock price, the higher the earnings yield; the stronger the growth, the faster the earnings yield rises. Therefore, a comprehensive assessment is necessary.
We previously mentioned that the more stable the earnings, the more suitable it is to use the price-to-earnings ratio for valuation; this also applies to earnings yield. Most broad-based indexes have earnings that are much more stable than their constituent stocks, making them suitable for measuring valuation using earnings yield. If growth rates are also similar, we can compare