Guide To Investing In Index Funds—What Is An Index Fund?
April 3, 2019
An index fund is a collection or portfolio of bonds and stocks that follow the performance of a financial market index.
A stock index measures the stock market or a section of the stock market.
One of the main advantages of investing in index funds is that it is a hands-off, low-risk type of investment.
It also has the potential of offering solid returns on your investment.
The index fund allows you to buy the stock of every firm listed on the index. Because of this, there are fewer swings in the market and low volatility.
This is unlike buying individual stocks.
An index measures the performances of bonds, stocks, and other tradable assets in the market. To track a specific index, you will need an index fund.
Some examples of indexes include:
•The Dow Jones Industrial Average – DJIA tracks the 30 biggest US companies.
•The S&P 500 – Standard & Poor’s 500 tracks the performance of the top biggest 500 companies in the United States.
•NASDAQ – this is a popular index that tracks 3000 technology companies.
•The MSCI EAFE Index – this index tracks both small-cap and large-cap companies that are located outside of both the US and Canada but located in developed nations.
These companies are in Australasia, Far East, and Europe.
•Russell 2000 index – (small cap) focuses on companies that have a market capitalization of less than $2 billion. It tracks 2000 of the smaller companies.
A few things to note about index funds
Here are some of the most important things to remember about index funds:
1. Index funds are available in various asset classes
As an investor, you can focus on companies in different industries as well as different capital values.
By choosing a market sector or industry, your portfolio is more diversified compared to purchasing individual stocks.
2. You can buy the whole market…indirectly
The index fund allows you to buy the stock of companies that make up the whole market or a section of the market.
For instance, if an index is tracking the S&P 500 –which comprises of the top 500 biggest US companies, the fund will buy shares from all the 500 companies that are listed on the index.
The investor will then purchase the shares on the fund. The value of this investment will mirror the gains and losses experienced by the S&P 500 index.
3. You can’t beat the market
There is a higher chance that you won’t beat the market by choosing individual stocks. Even professional account managers know this as they often will not outperform the benchmark index.
With index funds, however, the investor can meet the market gains.
Why invest in index funds
One of the main benefits of investing in index funds is the returns. While individual stocks have a higher level of volatility in that they may rise and fall, typically index funds tend to keep rising over the years.
Then there is the issue with administration fees that accompany managed accounts. Since index funds are a hands-free type of investment, you won’t experience costs that eat away at your returns.
After all, you don’t have to pay someone to analyze for you and tell you what to buy.
Your investment portfolio is more diversified with index funds. Your risk is spread around which gives the investor more security over their investments.
This is done by investing in the shares of different companies.
It is easy to invest in index funds. Often investment strategies can be complex and discourage first-time investors from committing their funds.
However, with index funds, all you need to do is buy and hold. They simply track the performance of an index.
Since index funds don’t trade in and out of securities as is often the case with actively managed funds, there is less taxable income. A cost that is often passed down to the shareholders.
The downside of investing in index funds
Index funds, despite them being a low-risk investment also come with some risk.
Granted, you stand to gain handsomely with a portfolio that rises with the index.
However in case, the market drops, so will the index fund.
With managed accounts, a competent manager may be able to outperform the market.
However, note also that finding one can prove a lot difficult.
You will likely not be able to outperform the market by managing the account yourself.
Index funds thanks to their diversification will even out the risks and reduce volatility.
On the other hand, this also reduces the potential of making huge gains.
Some underperforming stocks may pull down the best-performing ones.
Some frequently asked questions
Needless to say, there are many questions that come to mind when we talk about index funds, so let’s have a look at the most commonly asked ones!
How much money do I need to invest in index funds?
To invest in index funds, you can get started with just a few dollars. This means that pretty much anyone can invest in index funds.
That said, even while index funds are considered a low-risk type of investment, you should never invest with money that you cannot afford to lose.
How many index funds should I choose?
Since index funds are a diversified investment, you may only need to own one or two. This is especially if you are buying indexes such as the S&P 500 that track hundreds of companies.
If however, you choose indexes that track a sector of the market, you can buy even more to keep your investment portfolio well-diversified.
The final thoughts
Index funds together with mutual funds and ETFs have outperformed managed accounts over the years and decades.
They are a good choice for anyone looking for a dependable way to invest their money.
That said they are not all equal and it is important to do proper research before committing your hard-earned money!
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