Takeaways
- Index funds are passively managed with lower fees than actively managed funds.
- Index funds are portfolios of stocks or bonds designed to mirror a specific market index.
- Index funds are popular because of their access to low-cost diversification.
- Index fund investing can be a great way for beginner investors to get started.
- Index funds are considered core investments for personal and retirement portfolios.
Making your first investment can be an absolute thrill. But for some people, getting over the hurdle of purchasing their first investment is a challenge. This financial anxiety can hold you back from one of the greatest wealth-producing machines, the stock market. Investing in stocks for the long term can increase your net worth dramatically. For many investors, index funds offer the perfect first investment.
Index fund investing can be a fantastic way to dip your toe into investing while maintaining low risk and broad exposure. Index fund investing is easier than most because you don't have to choose a company to invest in or hire a financial advisor. Instead, you can invest in a low-cost index fund that tries to mirror a basket of stocks or bonds as closely as possible.
What is An Index?
An index is a group of securities that are used to track the performance of a sector of the market. For example, news commentators refer to the “Dow Jones” which is the Dow Jones Industrial Index Average. The Dow Jones Industrial Index is a collection of 30 prominent publicly traded companies’ equities. This index is a popular benchmark for the health of the overall economy because the index spans a wide variety of industries.
Here are some examples of popular equity indexes:
- NASDAQ
- Russell 2000
- Russell 3000
- S&P 500
- Dow Jones Industrial Average
- Wilshire 5000
Because indexes can consist of hundreds of underlying stocks or bonds, index funds give investors exposure to a wide set of underlying securities. The first index fund was created in 1975 by the founder of Vanguard.
What is An Index Fund?
An index fund is a type of mutual fund or exchange-traded fund that aims to track the performance of certain financial indexes or collections of stocks or bonds. If you invest in a Dow Jones Industrial Average or S&P 500 Index, you invest in a basket of stocks that seek to mirror the performance of either index.
The advantage is you do not have to buy all the shares that make up the index, but instead, you can purchase a piece of the DJIA or S&P 500 index and effectively buy the same exposure. Indexes save investors money and offer them diversification at the same time. Long-term investors love index fund investing as a baseline investment strategy.
How Do Index Funds Work?
Index funds are unique in that their underlying securities seek to mirror a specific index. Portfolio managers passively manage these funds, which keeps costs low. Index funds are initially constructed by portfolio managers carefully selecting stocks or bonds to mimic a particular index, like the S&P 500.
Smart Money -> What is the S&P 500?
Instead of curating a list of hand-selected stocks or bonds for the index fund, portfolio managers select stocks or bonds to match the index they aim to emulate. This can involve purchasing all the underlying stocks of an index, such as the S&P 500, or they can buy a representative sample of stocks.
Once the index fund portfolio is built, managers take a hands-off approach and passively manage the index. Index funds are attractive to investors learning to invest or nearing retirement because index funds provide investors with broad exposure (with a single investment), have low portfolio turnover (assets only change to reflect market changes), and offer low fees (not actively managed).
Advantages of Index Funds
Here are four reasons index funds are a favorite investment among investors:
1. Quick Diversification
Index funds are popular among new investors for their access to diversification. Investors use index funds to broaden their exposure to hundreds or thousands of stocks or bonds, depending on the index fund. Diversification helps investors minimize losses (if the fund does not perform well) and gives investors a great investment base to build upon.
Alternatively, if you are investing in a single bond or company stocks that underperformed, your investments are disproportionately affected by this loss. Index funds allow you to mitigate single-asset investment risk.
2. Low Fees
As a rule, actively managed funds typically have higher fees than passively managed funds. This is because, in actively managed funds, portfolio managers are hand-selecting individual stocks or bonds to put into their fund portfolio. However, with passively managed index funds, portfolio managers are only occasionally shifting core investments to mirror the index if an index’s underlying assets change over time.
3. Low Taxes
Index funds have a lower churn rate of investments in their holdings. Because of this, there are typically fewer capital gains distributions from the fund. This is compared to a dividend mutual fund that may specifically invest in regular capital distributions.
4. Market Performance
Index funds are not trying to beat the market. Instead, they focus on precisely replicating an index as closely as possible. In other words, they are trying to be the market.
Because they are focused on correlating to a particular market, they are not concerned about trying to invest in individual stocks. Data shows that passively managed funds typically beat actively managed funds [1]. This is because passively managed funds charge lower fees and deliver better long-term results.
Disadvantage of Index Funds
Here are some disadvantages to index funds:
1. Liquidity
You can order shares in an index fund at any time. However, share purchase only occurs after the market closes. For long-term investors, this type of intra-day limitation is not an issue. However, for intra-day traders, this limits when purchases can take place.
2. Low Risk
Because index funds give you access to a basket of securities, you lose your investment upside when you invest in index funds. Index investing is not a great way to inject alpha into your stock portfolio. Instead, investing in individual stocks might be a better portfolio solution to generate single stock risk.
How to Invest in Index Funds
Investing in index funds is straightforward. Here is how to get started investing in index funds today:
Create A Goal
The first step to making any investment is determining if the purchase aligns with your overall investment strategy. If your goals are to grow your money over time and establish an investment base, index fund investing could be perfect for you.
Solidifying your investment base is critical to increase your net worth over time. Taking advantage of different investment strategies, such as dollar-cost averaging, can allow you to accrue a meaningful base net worth.
Investing in individual stocks could be a better strategy if you are trying to make a quick dollar with trading market fluctuation.
Do Your Research
Not all index funds are created equal. Researching the index funds, you want to invest in is a critical part of due diligence.
Index funds can often give your portfolio exposure you would otherwise not be able to afford. For example, if you have been following healthcare companies and want to invest more in biotechnology stocks (which are considered riskier investments than more established companies) you might want to invest in a biotechnology index, such as the SPDR S&P Biotech ETF.
You can increase your exposure to index funds focused on:
- Market Capitalization: These indexes can focus specifically on micro, small, medium, large, or mega capitalization companies. These indexes concentrate only on company size and are industry-agnostic or industry-focused.
- Business Sector: Investors should invest in areas of the economy that interest them or where they have a particular skill set. For example, if you are highly interested or work in Consumer Package Goods companies, you can invest in index funds focused on this space.
- Asset Type: There are index funds that exclusively focus on specific types of asset classes, such as cash equivalents, bonds, or commodities – such as gold, silver, pork bellies, or corn futures.
- Geography: Investors often have difficulty gaining exposure to high-growth or emerging economies simply because of the logistics of international investing. However, index funds can allow you to invest in emerging growth geographies or specific geographic regions.
Whether you want broad stock market exposure or more acute bond exposure, index investing can allow you to calibrate your appetite for investing. Remember that focusing on the long-term is often the best investment strategy, but it is important to invest in areas you enjoy.
Choose Your Index
Once you select your index fund, it is time to begin investing. But before you pull the trigger to select which index fund to purchase, it is critical to compare index expenses.
While investing in index funds is a relatively low-cost venture, there can be differences in administrative fees between indexes. You will want to choose the lowest-cost index fund that gives you the highest correlation of exposure to an index because these fees lower your investment gains. The lower the expenses, the more money in your pocket.
Pick An Online Brokerage
For the average investor, the best place to purchase an index fund is through an online brokerage account. The three most vital items to consider are:
- Fund Selection: Not all online brokerage accounts offer the same fund selection, and some mutual funds will offer a more robust list of options.
- Trading Costs: If you invest in the long term, trading costs shouldn’t factor into your calculus too much. The critical piece here is to ensure you are not paying above market rate.
- Easy Access: Whether you invest through an online broker or a mutual fund, access is vital to making your investment. Once you have made your investment, you want easy access to monitor your investment performance.
Smart Money -> Best Online Brokers for 2023
Purchase Your Investment
Once you have decided how much to invest in your index fund investment, it is time to pull the trigger. By logging into your account, you can select the index fund you want to invest in. From there, you can titrate how much you are going to purchase.
Once you purchase your index fund, it will be a matter of monitoring your investment to ensure continued alignment with your investment philosophy and long-term financial goals.
Manage Regularly
You can’t manage what you don’t measure.
Investing in index funds is a fantastic way to build your investment base, but you will want to check in on your investments. Matching your expectations with your fund performance allows you to assess index fund performance and shift your investment strategy.
Smart Summary
Investing in index funds can be a terrific way for beginner investors to build an investment portfolio. Choosing the right investment strategy is critical for aligning your long-term financial goals with your investment approach. Whether you are saving for retirement or booting your personal stock portfolio, index investing can be a terrific low-cost option. Investing consistently is the key to building your net worth and is a smart money move.
[1] S&P Dow Jones Indices. SPIVA U.S. Scorecard. Last Accessed September 11, 2023.
Frequently Asked Questions
Index funds are fantastic for long-term investors. If you plan on holding your investment through the highs and lows of the market for many years, an index fund can be a great option.
Index funds have exploded in popularity since their inception in the 1970s. Trillions of dollars are managed in index funds each year because of their use in long-term investing strategies.
Investing involves a certain degree of risk. Knowing how much investment risk you can tolerate is your risk appetite and part of your investing strategies. Because index fund investing gives you exposure to the broad equity markets or a highly concentrated slice of the stock market, such as biotechnology funds, there is no guarantee for your investment returns. Choosing the best investment depends on your long-term goals.
Trying to time the market’s highs and lows is notoriously foolhardy. Even investment professionals do not time the market well. There is a term for this called the Efficient Market Hypothesis. The Efficient Market Hypothesis states that an active manager (you) cannot beat the market by choosing specific stocks to invest in. While you might get a higher return at first, your returns will fall in line with the market returns over time. That is why passive investing in index funds can be a terrific investing strategy.
