Index funds are a popular investing tool. In this article we break down their benefits and risks, and provide some real-life examples to help you choose the perfect index fund to suit your investment goals.
What is an index fund?
An index is a list of companies and a fund is an amount of money allocated for a specific purpose. For example, the S&P 500 index is a list of the largest businesses in the US. An index fund is a kind of a mutual or exchange-traded fund that follows the performance of a particular market, such as the S&P 500 or the FTSE 100. Investors manage index funds passively: rather than actively choosing stocks to invest in, they mirror a ready-made index.
There are various indexes, ranging from the ones representing the largest businesses on the market, such as the Dow Jones Industrial Average (DJIA) or FTSE 100, to indexes primarily focusing on technology, like the NASDAQ Composite (COMP).
How index funds work
Index funds replicate the market index. The S&P 500 index fund invests in the largest publicly traded companies in the US, mirroring their proportions in the actual index. That means the fund will grow or decline in value along with the S&P 500 as a whole.
Advantages of index funds
The benefits of index funds make them a perfect long-term investment choice.
Index funds adopt a passive strategy, tracking the index automatically. They do not require active management, so they have lower expense ratios (often under 0.1% per year). This makes them an affordable option for investors who want to minimize costs. In contrast, actively managed funds may charge from 1% to 2% per year.
There are lower taxes and fees due to lower transaction costs and reduced buying and selling.
Index funds are diversified by default — they hold a wide array of stocks within a market segment, and portfolio diversification is one of the best ways to protect your assets. An investor holding a single index fund gains exposure to various companies across a number of sectors, reducing the need for picking individual stocks. For instance, an S&P 500 index fund represents a broad cross-section of the US market by including companies from various industries. This reduces risk, as it minimizes the possible impact of one single stock’s underperformance. The profit from index funds is more stable because index funds do not rely on individual stocks.
Also, they show steady growth in the long run, compared to actively managed funds due to market-based performance and lower fees. A lot of broad market indexes, like the S&P 500, have trended upward over the long term. Due to the compound interest, index funds are perfect for saving for retirement. Also, due to their low expense ratios, index funds are a popular choice in retirement accounts like IRAs and 401(k)s.
Today, you can find index funds for almost every industry. It is a safe way to build a diversified portfolio and gain consistent profit with minimal effort.
Want to begin your investment journey? Get started with FBS!