Should You Invest in an Index Fund?

What It's About

Learn about this passive investment option and how it can help diversify your portfolio and decrease risk.

Index funds are a kind of investment fund that holds all the stocks in an index. The largest and most popular funds are based on the Standard & Poor’s 500 index, but many others exist.

Index funds seek to match the index’s performance as closely as possible rather than beat it. They are a passive investment vehicle, and tend to outperform most investors over time. Index funds can be set up as mutual funds or exchange-traded-funds. (Learn about the differences between ETFs and mutual funds.)  

With a diversified index fund and just a little knowledge you can start to invest successfully and inexpensively without taking on huge amounts of risk.

Index funds are one of the best inventions to ever hit the stock market, at least for investors. That’s a strong statement, but they do heavy duty for investors – reducing their risk, saving them on fees, and increasing their returns. Those are all great reasons why you need one.

Index funds reduce investors’ risk

The biggest appeal of index funds is that they do something that investors can’t readily do themselves – provide instant diversification through the purchase of one security. Based on a pre-determined index and allowing you to buy dozens or even hundreds of stocks at time, index funds immediately reduce your risk, even if you’re buying just one fund.

That’s the power of diversification. While all stocks have some risk, they don’t have the same risks. Some stocks go up, when others go down. Some are hurt if oil prices rise, while others thrive. By owning a huge swathe of them, you don’t have to worry much about which risks are in each stock. Even index funds based on a single industry – where the risk factors are similar – provide better diversification than owning just a few stocks in the industry.

So by buying a number of stocks all packaged into one easy fund, you instantly gain the power of diversification and reduced risk. Index funds are great for beginning investors who are unable or unwilling to research individual stocks, which is what you must do if you want to own them.  

Index funds save investors money

So they provide instant diversification, and that must cost investors something, right? Well, not really. In fact, index funds save investors money in many ways, not all of them so obvious.

Index funds tend to have very low expense ratios, because they’re based on an index and so are passively managed. That means the fund changes only if the index changes, and that doesn’t happen so often. So the fund managers who construct index funds don’t have to pay expensive portfolio managers to actively manage the fund, running up the tab in many ways.

The market’s cheapest funds tend to be index funds, either ETFs or mutual funds. Index funds based on the S&P 500 tend to be even cheaper, and they allow investors to get exposure to all 500 stocks in the index. It would be impossible for an individual to do this inexpensively. That’s a less obvious way that index funds save investors a lot of money.

In fact, some index funds have expense ratios of just 0.03%, costing just $3 for every $10,000 invested. Some fund managers such as Fidelity have reduced their expense ratios on a few funds to 0%. Fund managers are racing to the bottom on fees – and that’s great for investors.

Index funds increase investors’ returns

Not only do the funds offer their services at low fees, investors who take a buy-and-hold approach to index funds, especially well-diversified funds based on the S&P 500, tend to outperform investors who actively manage their portfolios. Investors in S&P 500 funds beat not only individual investors but also the professional actively managed funds.

That may sound surprising, but passive investing does very well. Over a one-year period in 2016, the S&P 500 index beat 85% of large-cap managers, according to a study by S&P Dow Jones Indices. But that was just an anomaly, right? Actually things got worse over a longer time frame, with the S&P beating nearly 92% of these pro managers over the prior five years.

If investors stick with a broadly diversified index fund such as the S&P 500, buy regularly, and continue to hold, they too can beat the pants off the professional money managers. And if you’re buying the whole market via an S&P 500 index fund, you’re the target. You are the market.

They’re great for beginners

Index funds are great for beginners because they allow you to start investing with just a little bit of knowledge. If you have a 401(k), then you may already be well on your way, because so many of these programs use index funds. With a diversified index fund and just a little knowledge you can start to invest successfully and inexpensively without taking on huge amounts of risk. So index funds are a huge win for individual investors.

By Mackenzie O'Connor
Wealthbase Contributor

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