"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 called "Foolproof Investment," which left a deep impression on me (I immediately added it to my "Recommended Reading List"). The author's biggest highlight is lowering the threshold of 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 advantageous investors who consistently lead the market over the long term.

Foolproof Investment

At this point, you might doubt my claims about why a simple strategy can make one of the top 10% outperforming investors. What are the remaining 90% of investors doing? The author has already answered this in the text, and it is the most insightful statement I have heard in years of learning about investing. Read on with this statement in mind, and I believe you will gain more insights.

Actions are based on thinking and cognition; if cognition is lacking, the implementation of actions will naturally seem exceptionally difficult.

Most stock investors want 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? It 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, hereinafter referred to as "stocks") and 50% in money market funds (such as Yu'ebao, hereinafter referred to as "cash"). Due to market fluctuations, stocks rise and fall, and by the end of each year, this ratio will no longer be the standard 50/50. At this point, a dynamic balance is needed 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, and it can basically be said to be invincible.

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

How should dynamic balance 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 underperforming or even declining. For example, if at the beginning of the year the allocation is 50/50, and by the end of the year the stocks have doubled, the actual ratio becomes 66.6/33.3. You need to sell some stocks to readjust back to the 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 as support. 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, even new entrants can easily surpass you; how can you stick to your strategy in such a market;
People tend to focus on short-term gains, and the potential returns from long-term strategies like 50/50 are easily 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 investment in emergency funds overlaps with the "cash" portion of the 50/50 strategy, the "cash" in the 50/50 strategy can be viewed as emergency funds. However, there is a prerequisite: sufficient self-discipline. If emergency funds are needed, they must be replenished immediately afterward.

Assuming A has a total of 200,000 funds, originally holding 60,000 as emergency funds, after starting the 50/50 strategy, there is no need to separately establish emergency funds, but rather 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 emergency funds, separate emergency funds must still be established to make up the difference. Again, taking A as an example, if there are 100,000 funds, then a 20,000 emergency fund account is needed, leaving 80,000 to invest in the 50/50 strategy, thus the total cash portion is exactly 60,000 (in practice, it is 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 the duration of investment, not just limited to a 50:50 stock-to-cash ratio, and can also include bonds and other assets. However, please note that the required adjustments should match personal cognition; if investment experience is limited, simply maintaining the 50% ratio is advisable, as doing too much can be counterproductive.

Key Quotes from "Foolproof Investment"#

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

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

I used to wonder why some simple investment rules are harder to apply for beginners; the reason is simple but rarely executed until I read this statement. This is my greatest cognitive gain from reading this book: simple actions often require a more complex and powerful cognitive system behind them; as the saying goes, "one minute on stage, ten years off stage."

The second major gain 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 once a year.

"Rebalancing is key."
"Asset allocation implies an inherent attribute—counter-cyclical investing (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 determine the execution of 'rebalancing' behavior."
"The key to whether 50:50 performs well lies in whether one can steadfastly execute rebalancing during the most frenzied market rises (selling stocks to return 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)."

"For so many years, although I have repeatedly read Graham's 'The Intelligent Investor,' and even to avoid being influenced by the bad habit of skimming through long-form web novels, I proposed 'one cannot read without copying,' and I seriously copied investment classics like 'The Intelligent Investor.' The effect of slowing down and savoring the reading 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? Making money would be a miracle."

So, reading should not be judged by speed; some books are more meaningful when read slowly.

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

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

To become an advantageous investor, one must start from within, first admitting that one is a loser, and only then can one humbly accept 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 'Common Knowledge of Family Health,' but what we receive is 'Human Anatomy.' In investment, there indeed exist some more fundamental yet crucial 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, distinguish between financial management and investment before making a choice; if it's just about financial management, then the 50/50 strategy is sufficient, and 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 once wanted to buy no longer appeal to you.

Chapter 1: Advice for Fund Newbies#

1.1 To Become Rich, You Must Accumulate Assets
If you are like most people and do not have much money on 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 use that 1,000 yuan to buy cigarettes; that is consumption. If you use that 1,000 yuan to buy Yu'ebao, that is purchasing an asset. Buying cigarettes means you have nothing left after smoking them, while Yu'ebao can help you increase your money and generate income.
True wealthy individuals hold a large amount of assets but would never spend on 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, working for decades in the same office building in his hometown, holding hundreds of billions yet never indulging in vanity.
Reducing consumption does not mean becoming a miser like Scrooge; it means being more rational about spending. 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 better cost performance; when our time is not worth much, we can spend more time reading and exercising, 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. By being more pragmatic in our consumption, we can save more money for investment, making it easier to embark on the path of "money generating money," thus making investment increasingly easier and achieving financial freedom faster.
1.2 Find the Asset with the Highest Long-Term Yield
There are many common assets in daily life, such as gold, government bonds, bank wealth management, P2P finance, stocks, real estate, commemorative coins, and commemorative banknotes, all of which are considered assets. So which one should we choose? Which one has better long-term returns?
First, 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%, then every year on June 1, we will receive 350 yuan in cash interest. 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 finance, etc.
Some assets cannot generate cash flow, such as gold; 100 years ago, 1 kilogram of gold, if properly preserved until today, is still 1 kilogram of gold, with no changes. For example, a piece of jade from the Ming Dynasty, calligraphy, paintings, or furniture, will not generate cash flow today. These are assets that cannot generate cash flow, such as precious metals, antiques, and artworks.
Why distinguish between cash-generating assets and non-cash-generating assets? This is because, fundamentally, the price-driving factors for these two types of assets are different.
Cash-generating assets primarily derive their price from 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, under the same risk conditions, we would choose the one with the higher interest rate. 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 and has stronger cash flow stability, without worrying about repayment at maturity.
Non-cash-generating assets derive their price primarily from 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 increases, leading to a supply shortage and a price rise. All non-cash-generating assets have prices determined by supply and demand.
After all this, we still don’t know which asset yields the highest returns!
There is a general concept: cash-generating assets usually yield 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 Investment Secret," has statistically analyzed over 200 years of the U.S. financial market and found that stocks are the highest-yielding assets for long-term investments, followed by corporate bonds and short-term government bonds. Moreover, no bond can outperform inflation in the long run; 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 of housing in Beijing's fourth ring, far behind inflation. Meanwhile, 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 possibly be the best long-term yielding assets?
This involves the issue of investment strategy; for the same PetroChina, Buffett makes money when he buys, while you lose money. What is the correct way to invest in stock assets? I will keep you in suspense; after reading the following chapters, you will naturally understand.
1.3 Look at Returns, But More at 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%, then without a doubt, this is a scam.
Although stocks have the highest long-term returns, they also have limitations. We cannot expect stocks to provide us with unreasonable returns. Long-term investment 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% annual compound returns. Some exceptionally skilled investors can achieve over 20% returns over decades. Don’t underestimate this return; stock god Buffett has maintained over 23% annual compound returns for over 50 years, making him the best in the world.
Next, I will recount two major financial scandals from 2015, Pan Asia and Jin Chaoyang. Through these two financial scandals, we can see through most financial scams and avoid losing the hard-earned money.
What happened with Pan Asia?
Not every financial scam starts with the intention to defraud; some collapse due to unreasonable design patterns, like Pan Asia.
Pan Asia was a financing investment platform. The operating model of this platform was as follows: if a company held metals, it could pledge them on Pan Asia for financing according to Pan Asia's metal prices; where did the funds come from? From investors. Investors transferred their money to Pan Asia, which then lent it 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, Pan Asia had two notable differences that led to its collapse.
The first was high returns. When companies could not repay loans, the platform could sell the collateral to recover cash, ensuring that investors' principal would not be lost. Pan Asia's main product was a daily gold treasure, which had high liquidity and promised 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 had only two options: repay loans with collateral or borrow new to pay old, surviving day by day.
The second was that the collateral, i.e., metal prices, were based on Pan Asia's trading prices, not the market trading prices for commodities. Pan Asia's prices were much higher than the normal market prices, leading to the true value of the collateral being insufficient to repay the loans.
Pan Asia promised high returns to investors, obtained funds from them, and lent them to companies; however, companies could not bear the high capital costs, and the assets pledged to Pan Asia could not repay the debts, leading to a situation where Pan Asia could not recover its principal, resulting in increasing defaults, and ultimately its collapse was not surprising.

What happened with Jin Chaoyang?#

Although not as famous as Pan Asia, Jin Chaoyang's case involved even more money, making it the largest financial scam in the first half of 2015.
Unlike Pan Asia, which collapsed due to model defects, Jin Chaoyang was designed from the start to defraud.
"After joining Jin Chaoyang, we first borrowed money to buy luxury houses or cars, using them as assets to continuously leverage loans from banks, then continued to leverage operations to obtain funds, and finally invested some of that money into Jin Chaoyang's Pre-REITs and corporate short-term bonds issued by Jin Chaoyang, with Pre-REITs yielding up to 100% at their peak and at least 40% at their lowest, while 'corporate short-term bonds' previously had annual yields as high as 36%," said a former Jin Chaoyang BCC student.
Jin Chaoyang's income came from two parts: one was the tuition fees collected, with the highest-level course costing around 80,000 for three months, and just from tuition alone, Jin Chaoyang earned 28.8 billion; the other part came from the funds students invested in high-interest financial products, with Jin Chaoyang continuously using new funds to pay interest on previous financial products, making it a typical Ponzi scheme.
How to avoid financial scams?
Pan Asia initially had government backing, and even banks helped sell it; Jin Chaoyang had many wealthy participants, making it seem very credible. However, these scams all share a clear characteristic: they promise unreasonable high returns.
Pan Asia promised a 13% return on daily wealth management products, while Jin Chaoyang promised annual returns of 30% to 100% on wealth management products; in reality, no wealth management path can sustain such high returns. Even stock god Buffett, with an average annual compound return of 23% over decades, is at the top level globally. If any platform promises all participants a 30% return, is that possible? Even if this platform has state backing, unreasonable high returns cannot sustain because finance has its own operational 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’s a small example.
In January 2015, the famous He Dong Garden in Hong Kong was sold for 5.1 billion HKD. This investment by Sir He Dong 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 annual compound return? 13%.
In other words, if you currently have a correct investment strategy that can achieve a long-term annual compound return of 13%, then your 100,000 yuan 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 yuan will only be worth 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; I will introduce the most suitable fund for office workers—index funds.
1.5 The Best Fund for Office Workers—Index Funds
We often encounter the term "fund," such as stock funds, bond funds, mixed funds, and so on, which can often confuse people. What exactly do these funds do?
Simply put, a fund is a basket that can hold various assets according to pre-set rules. The benefit of this is that it divides a basket of assets into several small portions, allowing investment with relatively small amounts of money, enabling investments that we could not afford before through funds.
For example:

A basket containing various short-term bonds, short-term wealth management, and cash is a money market fund.
A basket containing various corporate bonds and government bonds is a bond fund.
A basket containing stocks from various companies is a stock fund.
A basket containing 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 various 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 use passive investment, selecting a certain index as a benchmark, and purchasing all or part of the securities contained in that index according to the standards set by that index, aiming to achieve the same level of returns as that index. By investing in stock funds long-term, we can also achieve 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 annual compound return is 13.2%! If we held the Hang Seng Index Fund, we could achieve such a high increase. Even in the A-share market, which is often criticized, the overall increase has also exceeded 40 times since its inception. If we held the A-share index fund, we could average such returns.
Even if we choose an index fund, there are still over 100 available on 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 funds are available for redemption on platforms like Tian Tian Fund, Taobao, and JD. Redeeming exchange-traded funds on different websites is just a matter of different channels, and the funds are the same. Therefore, 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 large 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 to settle is shorter. Friends who have redeemed stock funds at banks or websites know that redeeming stock funds takes a relatively long time for cash to arrive, generally requiring 5 working days, while some efficient funds can do it in 3 working days. In contrast, the settlement time for ETFs is the same as for stocks; they can be sold on the same day, and cash can be withdrawn for use the next working day, making it more convenient and faster.
Third, ETFs tend to have better long-term returns, making it worth the trip to open 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 a securities company customer service, so I won’t elaborate further.

Chapter 2: Understanding Indexes#

In the previous chapter, we introduced the classification of funds. Among them, there is a type of fund that stock god Buffett has repeatedly introduced in public, which is index funds. This is also the investment type that this book focuses on. From this chapter onward, 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 the CSI 300 Index we often refer to.

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 indexes, and the Shenzhen Stock Exchange develops the Shenzhen series indexes, both of which belong to exchange-developed indexes. The China Securities Index Company develops the CSI series 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 Hang Seng Company mainly develops indexes, 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 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, perpetual, passive, cyclical, 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; calculate an average score for each class and compare these averages.
This is the role of an index, to calculate a weighted average to show the average value. The functions of different indexes are similar, but the difference lies in the different constituent stocks determined by their rules and the different weights measured during weighting.
At the same time, due to the law of large numbers, theoretically, the larger the sample space of the index, the more effective the index is.
An index is a rule, possessing perpetuity, passivity, and cyclicality.
The existence of rules provides perpetuity. The rules of the SSE 50 index 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.
Moreover, 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 repeatedly, so there is no need to worry about missing out on buying opportunities during undervaluation or selling opportunities during overvaluation.
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 fully possesses all the characteristics of individual stocks, including profits, liabilities, assets, sales revenue, etc. We can analyze the index using individual stock strategies.
We also know that individual stocks have many unpredictable risks: for example, accounting fraud, long-term suspension of trading, dilution of existing shareholders' earnings, and unforeseen black swan events by 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 market average; 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 continuous 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 only recommended them after recognizing these benefits of index funds.
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 get 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 proportion of the index's constituent stocks, it can replicate the index's performance; this is an index fund.
For example, there are more than seven ETF funds tracking the CSI 300 Index. These seven funds all track the CSI 300 Index, but they are products developed by different fund companies.
3.2 The Errors of Index Funds
An index is a mathematical formula, but turning it into a tradable financial product involves some errors, so index funds also need to be carefully selected.
From the stock market crash in 2015 and the liquidity crisis, it can be seen that different companies have very different experiences in dealing with large redemptions. The top 10 fund companies outperform smaller 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 a large tracking error between the fund and the index; cross-border index funds have exchange rate risks, etc. When operating these funds, a larger safety margin should be left. For example, the H-share ETF has more than 10% of cash not invested, and it also has exchange rate risks, so when investing in it, a larger safety margin should be reserved.
Therefore, 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 rates than off-exchange funds, resulting in smaller errors.
Error 4: Exchange rate risk—cross-border index funds have exchange rate risks.
Error 5: The scale and operational history of index funds—larger scale and longer operational history index funds from large companies perform better 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 from companies that have delayed building positions for a long time.

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

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 five stocks not exceeding 60% of the index, and the average daily trading volume of the constituents 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 would also add another criterion: the variety of industries included should be diverse.
The CSI 300 includes 300 stocks, covering various industries. Compared to a financial index, which focuses solely on the financial sector, the CSI 300 is more stable. If the economy is not doing well, the financial index may be dragged down by banks, but the bank's proportion in the CSI 300 is lower than that in the financial index, making the CSI 300's profitability more stable.

This is the biggest advantage of broad-based indexes: they include various industries, making profitability far 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 to broad-based indexes are industry indexes.

Industry indexes are also categorized by industry, divided into primary and secondary industries, etc. What are primary and secondary industries?
For example, energy is a primary industry; the oil industry falls under the secondary industry of energy, and oil extraction is even more finely divided into a tertiary industry. The most granular level of industry classification is individual stocks.
Industry indexes carry more industry characteristics, and the 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, NASDAQ, etc.

Chapter 4: Valuation of Index Funds#

4.1 What is Valuation?
Assets can be viewed from many different angles. For example, from a price perspective, each asset can have a market price that indicates its current market trading price.
Valuation is the assessment of assets from various perspectives. For example, from the perspective of asset profitability, from the perspective of asset value, etc. We primarily invest in stock index funds, so we need to understand common stock valuations.
In the early days, stocks had no valuations; 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. Each has its 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. The static PE uses the company's net profit from the previous year, the dynamic PE uses the estimated net profit for the next year, and the rolling PE uses the net profit from the most recent four quarterly reports. The most meaningful is the 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 everyone's valuation of unit profits.
The applicable scope of the price-to-earnings ratio: good liquidity and stable profitability.
The price-to-earnings ratio includes two variables: market price and earnings. Therefore, the prerequisites for applying the price-to-earnings ratio are twofold: one is good liquidity that allows for market price transactions, and the other is 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, but such high-flying stocks have lost their reference significance. Because these stocks have poor liquidity, even a small amount of funds can cause wild price fluctuations.
The poorer the liquidity of a stock, the less reference value the price-to-earnings 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 1,000 yuan, and their PE ratios may even be below 0.1. From a valuation perspective, this is as low as it can get. However, when you try to invest, you may find that to buy this stock, you might have to bid much higher 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 the stock to its daily limit up or 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 reasonably good liquidity is a prerequisite for applying all valuation indicators. Generally, stocks that can enter indexes like the CSI 300 or CSI 500 have no liquidity issues.
Stable Earnings
This is the second prerequisite for using the price-to-earnings ratio. Some industries have unstable earnings and are not suitable for the price-to-earnings ratio, such as declining industries with "price-to-earnings ratio traps" and cyclical industries. Some industries are in a growth phase or are losing money, making them unsuitable for the price-to-earnings ratio.
Price-to-Earnings Ratio Traps
Industries with price-to-earnings ratio traps are mostly declining industries and cyclical industries.
Some industries have very low price-to-earnings ratios, but in reality, the industry has entered a downward cycle, and profits are continuously decreasing. From the perspective of PE = P/E, as E decreases, PE gradually increases, no longer undervalued. This is the "price-to-earnings ratio trap."
Cyclical industries are also not suitable for the price-to-earnings ratio. For example, in the securities industry, profits can surge several times during a bull market, and the original PE of 40-60 can suddenly drop to single digits. From the perspective of the price-to-earnings ratio, it seems 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 back to the tens.
Many industries are cyclical, such as steel, coal, securities, aviation, and shipping. Industries that provide homogeneous products and services tend to exhibit significant cyclicality and are not suitable for valuation using the price-to-earnings ratio.
Growth Stocks and Loss-Making Stocks
It is evident that loss-making stocks cannot use the price-to-earnings ratio as a metric. 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 valuation using the price-to-earnings ratio.
For liquid and stable earnings stocks, the price-to-earnings ratio can be used for valuation. Most broad-based index funds can 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, also known as the book value.
Net assets, in simple terms, are assets minus liabilities, representing the equity shared by all shareholders. Specific calculations can be found in the annual reports of listed companies. This financial indicator is generally more stable than earnings. Moreover, most companies' net assets tend to increase steadily, making it possible to calculate the price-to-book ratio.
Factors Affecting the Price-to-Book Ratio
Efficiency of Asset Operation: ROE
When discussing the price-to-book ratio, we must mention the return on equity (ROE). ROE is the return on net assets, calculated as net profit divided by net assets.
For a company, assets are the materials for operation, and the company needs to operate these assets to generate returns; otherwise, these assets have no value. The same assets can yield higher returns for some companies, indicating higher asset operation efficiency. The key indicator for measuring asset operation efficiency is the return on equity (ROE).
In my opinion, ROE is the most critical operational indicator for a company. Buffett's old 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's profit has been 6% of capital (i.e., ROE 6%) for 40 years, then 40 years later, your average annual return will not differ from 6%, even if you initially bought it at a bargain. If the company's profit is 18% of 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 operation efficiency, and thus the higher the price-to-book ratio.
Stability of Asset Value
Assets come in various forms; some can appreciate over time, while others can depreciate rapidly.
For example, Moutai, the white liquor being brewed, will appreciate over time; however, computer chips produced by Intel will depreciate rapidly if not sold in time.
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 brand value, senior technical engineers, company patents, channel influence, and industry voice.
If a company primarily relies on intangible assets for operation, like law firms, advertising service companies, and internet companies, the price-to-book ratio has little reference value.
Increased 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 the 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 mostly relatively easy to measure in value and long-term preservation, such as factories, land, railways, and inventory. Such companies are suitable for valuation using the price-to-book ratio. If cyclical stocks primarily consist of tangible assets and those assets maintain long-term value, then those cyclical stocks are very suitable for valuation using the price-to-book ratio. Industries like securities, aviation, shipping, and energy are all suitable for valuation using the price-to-book ratio. Therefore, some cyclical industry index funds are suitable for valuation using the price-to-book ratio; if broad-based index funds encounter short-term economic crises and unstable earnings, the price-to-book ratio can also be used as a supplementary valuation method.
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 ownership of equity assets.
What is the difference between dividend yield and payout ratio?
Dividend yield and payout ratio are similar concepts, but they are different.
In simple terms, 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. The numerators are the same, but the denominators differ: one is the company's market value, and the other is the company's net profit for the 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 from the previous year in cash dividends. In contrast, the dividend yield fluctuates with the stock price: 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 huge funds 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 barely 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 income has increased significantly, in sync with performance growth.
You can obtain continuously growing cash flow without selling your equity. 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 State Capital Investment Corporation, 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 payout ratio, thus obtaining high dividends each year.
Dividends are an excellent way to hold equity assets long-term while enjoying cash flow returns. By holding a high-dividend stock asset portfolio for a long time, you can achieve financial freedom easily through steadily increasing cash dividends without worrying about the fluctuations in stock prices.
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 include a basket of stocks, and essentially, stock funds are a special type of stock. Therefore, stock valuation methods are also applicable to stock funds. However, stock funds include dozens or even hundreds of stocks, making it very cumbersome to calculate the valuation of stock funds on your own, so most stock funds do not calculate valuations.
Fortunately, as mentioned earlier, the goal of index funds is to replicate the index, and the index is developed by exchanges or index companies. Exchanges and index companies publish the valuations of indexes, which can essentially be regarded as the valuations of index funds. These valuations can be found on official websites. Here’s a brief explanation of how to find them.
Method 1: Follow My Xueqiu
I know that finding index valuations is not easy, so I have compiled the valuations of various indexes and will publish the price-to-earnings and price-to-book ratios of index funds after the market closes every trading day. In the future, I will also add the valuations of major global indexes for easy reference.
You can directly follow my Xueqiu: search for "Bank Screw" and follow me.

When you read this book, it may have been some time since I wrote it, and the methods introduced may have changed. You can also directly ask me 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, SME Index, Dividend Index, and CSI Dividend can all be viewed on the China Securities Index official website, with daily updates.
Website: http://www.csindex.com.cn/sseportal/csiportal/zs/jbxx/daily_index_info.jsp.
Method 3: Shenwan Historical Data
Download from this website: http://www.swsindex.com/idx0510.aspx.
You can use Excel or MATLAB for 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 lower fees and other advantages, I will introduce ETF index funds.
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 Company’s Hang Seng National Enterprise Index. It tracks the Hang Seng H-share Index, mainly consisting of large domestic state-owned enterprises listed in Hong Kong, with major constituent stocks similar to those in the SSE 50.
The H-share index currently has the lowest valuation among all broad-based indexes, with a PE ratio of only over 8, making it the lowest globally, except for Russia and Brazil. Not only is the valuation low, but its historical profitability is higher than that of the S&P 500 Index during the same period, making it a good index.
There are always people saying that Hong Kong stocks have poor liquidity and are becoming marginalized, making them not a good 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 also yielded significantly 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 when buying, the better the returns.
Backtesting the historical data of Hong Kong stocks over the past 30 years, buying below 10 PE and holding for over 9 years has a high probability of yielding over 6 times returns. If the valuation is lower, the yield will be even higher. The current valuation of the H-share index is not the lowest in history, but it undoubtedly falls within the absolute undervaluation range, making it a good choice for regular investment.
Currently, 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 selects 50 stocks with large market capitalization and good liquidity from the Shanghai stock market, weighted mainly 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 indexes seem to 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 basically well-known stocks like the "Big Three" and oil and petrochemicals. 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 if the H-share index seems to have not risen as much as A-shares; it appears to have performed poorly; should we still choose it?

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 the dividends. If we consider dividends, the SSE 50's closing points on the 25th would be 3,120, with an annual compound return of 10.8%; while the H-share index, considering dividends, would have a closing point of 17,441, with an annual compound return of 14.5%, far exceeding the SSE 50's annual compound return!
From a long-term return perspective, the SSE 50 significantly lags behind the H-share index, as the latter 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 discount for the SSE 50 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, such as in 2013-2014. However, we can draw a conclusion: for two indexes with similar fundamentals, 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 error margins.

5.3 Hang Seng Index
I often see friends confusing 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 blue-chip stocks in the Hong Kong market, selecting the 50 largest and most liquid companies from all listed companies on the Hong Kong Stock Exchange to reflect the overall level of the Hong Kong stock market, with the maximum proportion of any 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 also places great emphasis on liquidity. In this regard, the Hang Seng Index's positioning is somewhat similar to that of the CSI 300, but it has fewer constituent stocks than the CSI 300.
The Hang Seng Index is also the oldest among the indexes closely related to A-shares. The Hang Seng Index was established on November 24, 1969 (although 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 annual compound return of 11.2%. This return may not seem high, but this point does not consider dividends. If we take dividends into account, the total return index for the Hang Seng Index is 55,439 points, with an annual compound return of 13.2%. Considering that the Hang Seng Index had a relatively high valuation at its inception, this return can still be considered good. This is also the advantage of the Hang Seng Index, which has achieved an average annual return of 13.2% over more than 40 years.
As a mature trading market, the valuation distribution of Hong Kong stocks is also relatively reasonable. The Hong Kong Stock Exchange is closely related to A-shares, and the system is also very sound. 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.
(Note: "Old Thousand Stocks" are a feature of the Hong Kong stock market. From the perspective of 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 price-to-earnings ratios of less than 0.1. However, many of these "Old Thousand Stocks" appear to be undervalued and look cheap, 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, minimal dividends, and constant financing through stock issuance 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 market. This is also reflected in the Hang Seng Index: the current dividend yield of the Hang Seng Index is around 4%, significantly higher than the current dividend yield of 2.05% for the CSI 300.
As mentioned earlier, the total return index of the Hang Seng Index, considering dividends, is more than double that of the total return index without considering dividends, with dividend income contributing to a significant portion of long-term investment returns. This aligns with Professor Siegel's conclusion that "the primary source of returns from long-term stock investments is dividend income."
Of course, the Hang Seng Index also has its drawbacks, with half of its constituent stocks being in the financial sector, which is not lower than that of the CSI 300. If there are concerns about bad debts in mainland bank stocks, 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, which has basically reflected the negative expectations.
Next, let’s discuss the valuation and investment value of the Hang Seng Index.
The following chart shows the price-to-earnings ratio curve of the Hang Seng Index since 1973, along with the frequency distribution of different price-to-earnings ratios.

From the chart, we can see:

(1) For the vast majority of the time, the valuation of the Hang Seng Index appears around the average valuation of 14.46 times;
(2) 68% of the time, the valuation of the Hang Seng Index appears around 14.46 times, which is the normal valuation range for the Hang Seng Index, between 11 and 18 times PE;
(3) 16% of the time, the valuation of the Hang Seng Index is below 11 times, which is the undervalued area; 16% of the time, it is 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 broader 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. When entering undervaluation, buy in batches; when entering overvaluation, sell in batches. This is a more realistic approach.

Currently, the price-to-earnings 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, and a return to above the median valuation is highly probable.
There are several ETFs tracking the Hang Seng Index, and I recommend the Huaxia Hang Seng ETF (159920), which is established through the Hong Kong Stock Connect channel. Huaxia 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-cap-weighted indexes. Here, I will introduce a strategy-weighted index: the Dividend Index.

Generally speaking, strategy-weighted indexes can outperform similarly positioned market-cap-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, largest market capitalization, and best liquidity from the Shanghai Stock Exchange over the past two years. Generally, stocks with high dividends in A-shares are mostly blue-chip stocks from 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.
Investors 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 while not reducing their ownership of the company. If one wants to achieve financial freedom through the stock market, having a portfolio of high-dividend stocks that provides gradually increasing cash dividends is the best choice.
Moreover, there is sufficient evidence that high-dividend stocks tend to have higher long-term returns. In "The Long-Term Investment Secret," Siegel backtested the data of the S&P 500 from 1871 to 2012 and found that dividends were the most important source of shareholder returns during that entire period. Starting from 1871, the actual yield of stocks was 6.48%, with dividend income accounting for 4.4% and capital gains accounting for 1.99%.
What has been said about stock dividends also applies to fund dividends.
The index we usually refer to does not include dividends. On the official website of the SSE Index, it can be seen that indexes generally have a total return index, which considers the dividends and reflects the returns. Taking the Dividend Index as an example, the current index is at 3,170 points, while its total return index is at 4,404 points, with the difference due to dividends.
The following chart shows the annual dividend records of the Dividend ETF:

Index funds strictly track the index, so cash dividends will affect the fund's tracking. The fund will accumulate the dividends from stocks and distribute them in cash periodically. The Dividend ETF performs well in this regard, achieving cash dividends almost every year. If considering long-term holding for cash dividends, the Dividend ETF is a good choice for long-term retirement planning.

Chapter 6: How to Invest in Index Funds?#

Although index funds have many benefits, it does not mean that we can randomly invest in index funds and make money.
If we had invested in the CSI 300 during the bull market of 2007, we might still be stuck today. Therefore, a correct strategy is also needed 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. One of the most important characteristics is perpetuity.
Let’s illustrate this with the U.S. stock market.
We all know that the history of the U.S. stock market is much longer than that of the A-share market. There is a very famous index in the U.S., called the Dow Jones Index. The Dow Jones Index was established in 1884, consisting of the 12 most influential stocks in the U.S. at that 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 General Electric remains today.
In other words, if we had bought any of those 12 stocks at the time, none of those stocks would exist today.
From this, we can see the biggest advantage of indexes compared to individual stocks: we call this advantage perpetuity. Perpetual operation is something every enterprise dreams of, but in reality, very few companies can 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 falsifying profits. Therefore, if we want to build a long-term investment plan for ourselves that lasts for decades, index funds are an excellent choice.

6.2 Why Index Funds Don’t Make Money?#

Since index funds can exist perpetually, does that mean we can buy and sell index funds at will and 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.
Ordinary retail investors would typically ride the wave and invest more money in the same fund. If we invest another 100,000 yuan, we may find that we haven’t made a single penny and have even lost over 10,000 yuan.
Many people would wonder why they made money the first time they bought the fund but lost money the second time?
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 costs 4 yuan, and you pay 8 yuan for it, you’ve overpaid; if a house is worth 1 million, and you pay 2 million for it, you’ve 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 sufficient.
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 and Buffett's teacher. Buffett even named his eldest son "Howard Graham Buffett" in honor of 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 market price divided by earnings, while earnings yield is earnings divided by market 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 conveniently compare index funds with bond yields, other index funds' earnings yields, real estate rental yields, bank wealth management annual returns, etc., to select the most worthy investment category.
In simple terms, earnings yield allows us to view stocks as a special type of bond, with 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 across various countries, we find that in most stock markets, when the bear market is at its lowest valuation, the price-to-earnings ratio is usually below 10, meaning that the earnings yield is above 10%. Graham used this earnings yield as the first criterion 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 in history.

So what is the second criterion? Graham believed that only when the earnings yield is more than double the yield of government bonds should we consider buying stocks.
These are the two simple criteria Graham used for buying stocks based on earnings yield.

(1) The earnings yield must be greater than 10%;
(2) The earnings yield must be more than double the yield of government bonds.
Index funds that meet these two criteria 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 index was around 20 times, translating to an earnings yield of only 5%, far below double 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 to sell a fund for profit? 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 selling to buy new shares. John Neff believes that buying is for selling; he sells stocks at appropriate valuations.
The selling strategy I use primarily refers to Graham's thinking. This strategy may not apply to all types, but it is relatively applicable to current index funds.

Earnings Yield: Measuring the Relative Investment Value of Stocks
We have already learned 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 as long as the stock market exists, stock indexes will also 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 the growth rates are also similar, we can compare earnings yields to discover investment value. Most national stock market indexes are suitable for using Graham's method, such as the S&P, NASDAQ, CSI 300, SSE 50, H-share Index, Dividend Index, etc.