Looking for a little investment advice? You couldn’t do any better than Warren Buffet, one of the most well-known and well-respected investors of our time. Warren Buffet recommends that everyday investors take advantage of index funds.
These low-cost, low-risk financial vehicles can be perfect for the average investor. Even seasoned experts can make index funds a part of their overall portfolios.
So what is an index fund and how does it work? Are index funds diversified? In this article, we’ll explore the nature of index funds, helping you to understand how these funds can enhance your financial portfolio or get your start in the world of investing.
What Are Index Funds?
The term “index fund” can apply to a mutual fund or an exchange-traded fund (ETF), but index funds are unique in their relationship to financial benchmarks.
Let’s take a look at some of the elements that make up an index fund.
Index Funds: Definition of the Term
An index fund pools investors’ money to purchase a portfolio whose stock performance mimics a market index.
In other words, your stock portfolio will match the performance of an entire stock index, such as the S&P 500.
Other investment strategies attempt to beat or out-perform the market, which can be an aggressive strategy that carries some risk. But an index fund simply aims to mirror the performance of the index as a whole.
What is an Index?
An index is the measure of the performance of stocks, bonds, or other assets. You might already be familiar with “the Dow,” which refers to the Dow Jones Industrial Average. An index fund, therefore, attempts to mirror the performance of a particular index.
Common examples of well-known indexes include:
- The Dow Jones Industrial Average
- S&P 500
- Russell 2000 Index
- The MSCI EAFE Index
- The Wilshire 5000 Total Market Index
Each index fund will track with its individual index. For example, an index fund may track with the Nasdaq index or the S&P 500. The point is that the portfolio will only select options from that individual index, which means that investors won’t be able to select individual stocks to add to their portfolios.
How Do Index Funds Work?
When you invest in an index fund, your portfolio will contain a representative sample of the stocks represented by that index.
For example, the S&P 500 index includes the 500 largest companies in the United States. If your index fund tracks the S&P 500, your portfolio will contain shares from as many of these companies as possible. That way, when the total index performs favorably, you’ll see a matching increase in your portfolio’s performance.
Basically, index funds operate on a basic strategy: If you can’t beat ‘em, join ‘em. While other approaches seek to purchase individual, high-performing stocks, an index fund simply tries to mimic the success of the entire index. With an index fund, if your index performs well, so does your portfolio. It’s that simple.
Recent research has shown that 90% of active fund managers fail to meet their benchmark index. That means that trying to actively select stocks may not be nearly as effective as an index fund that simply tries to match the index’s performance.
What is Index Fund Performance Measured By?
The performance of your index fund is designed to match the performance of your associated index. That means that when your index performs well, you can generally expect to see your portfolio experience similar gains.
However, because your portfolio only contains stocks that are representative of the index as a whole, your index funds won’t always match the index performance perfectly. Still, differences tend to be slight, making index funds one of the industry’s more predictable investment options.
Are Index Funds Diversified?
As you may have already guessed, index funds are diversified by their very nature. An index fund selects a diverse selection of stocks from within a particular index. In fact, the more diverse your portfolio is, the more likely it is to mirror the performance of your market index.
How Are Index Funds Managed?
Index funds are passively managed, which means that they offer a hands-off approach to investing. In an actively managed strategy, your portfolio is continually adjusted to maintain optimal performance. But a passive approach doesn’t require these types of adjustments, which also means you can save on fund manager fees and commissions.
Index Funds vs. Mutual Funds
Index funds can actually be a type of mutual fund, though with some key distinctions. Let’s take a look at the core differences between index funds and mutual funds.
How Stocks Are Chosen
Typically, a mutual fund seeks to invest in a wide array of stocks and assets, all chosen by a fund manager. An index fund only invests in the stocks represented by a specific index.
Index Funds Have a Unique Strategy
Mutual funds attempt to select stocks that will outperform the market. Index funds attempt to replicate the success of a particular market index.
Index Funds Cost Less
Actively managed mutual funds typically have higher fees than index funds do. While not all index funds are priced the same, they can be ideal for entry level or everyday investors.
Index Funds Are More Predictable
The performance of a mutual fund can be varied and somewhat unpredictable. After all, your mutual fund is composed of a variety of stocks that were chosen to out-perform the market, which they may or may not do. But because an index fund is intended to mirror a particular index, they tend to be much more predictable. If your index performs well, so does your portfolio.
Index Funds vs. ETFs
Index funds offer many of the same benefits as exchange-traded funds (ETFs), including their low cost and high possibility of rewards. But index funds are a bit different, and these differences may be important for understanding your investment strategy.
Index Funds Aren’t Set Up for Day Trading
With an ETF, you can buy and sell throughout the day, just like you can with stocks. But index funds can only be bought and sold for the price set at the end of the trading day. This means that index funds simply aren’t set up for day trading. They make more sense for long-term investors.
Index Funds Have a Higher Minimum Investment
While every fund is different, index funds will typically have a higher minimum investment requirement than ETFs. It may be possible to find a broker with no minimum investment requirement, but otherwise, you should expect to put $2,000 to $3,000 into your initial index fund investment.
Index Funds Aren’t as Tax-Efficient as ETFs
Index funds are more tax efficient than a typical mutual fund, but ETFs tend to be the most tax efficient option. This is because ETFs rely on stock trades between individual investors, which keeps taxable transactions to a minimum.
Index Funds Require Less Work
ETFs offer a lot of value, but in the end, index funds tend to be a lot less work. With an index fund, you’re simply relying on your index to perform well, which is a simpler approach than either mutual funds or ETFs.
Is an Index Fund Right for Me?
Every investor has different goals. Index funds can be a great strategy for both entry-level and long-term investors. If any of the following criteria apply to you, you may wish to consider investing in an index fund:
You Prefer Lower Risk
Index funds mirror their associated index, which means that there’s less risk than more aggressive strategies that seek to outperform the market.
You’re Not Interested in Picking Your Own Stocks
In an index fund, your portfolio simply tries to contain a representative cross-section of the index as a whole.
If you’re interested in researching and selecting your stocks, an index fund may not be right for you. But if you’re comfortable with a passively-managed portfolio containing a diverse array of stocks, an index fund may spare you the task of researching stocks and making careful choices.
You’re Interested in Long-Term Investments
Think of index funds as the tortoise, and other types of investments as the hare. Your gains will be slow and steady, but that provides a recipe for future victory.
Those who are seeking a new tool for day trading or short-term investments should consider other forms of financial products.
But index funds can be ideal for those who want a low-cost, low-risk, no-hassle approach to investment and are comfortable seeing their investments grow with time.
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