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What is an index fund and how does it work? More importantly, is it the right place for you to invest? Investing in index funds could be a key wealth-building strategy. Check out the pros and cons. Plus, 5 questions to ask yourself before jumping into index funds.

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What is an index fund and how does it work?

Investing choices can be overwhelming. Index funds are a simple way to start investing today, and offer many advantages.

Creating a wealth-building formula for your investment portfolio can be tricky. After all, the choices seem to be as numerous as the grains of sand on the seashore. If you feel like giving up before you even get started, I have good news for you. Read on about “what is an index fund and how does it work.”

Index funds offer a simple, easy, low-cost route to wealth. Even better, you can automate your contributions to your index fund account so your wealth grows automatically… no matter how chaotic life gets.

And that’s a godsend for busy people… for those who don’t have much money to invest at the beginning… and for those who don’t want to spend their precious time picking stocks.

Index funds offer a smart, hands-off way to invest. But like all things, they’re not perfect. Find out if index fund investing is a good match for you.

What is an Index Fund and How Does It Work?

In order to understand what an index fund is, you need to know what an “index” is. We discussed indexes in considerable detail here. In short, it’s a bunch of stocks grouped together based on some common factor, and weighted in some fashion.

Indexes report their numbers as a weighted composite of their entire group of stocks.

By extension, an index fund is a type of mutual fund or ETF that seeks to mirror the returns of a specific market index, such as the S&P 500. You can’t invest directly in the S&P 500. But you can do so indirectly by investing in an index fund.

When you buy an index fund, you’re buying shares in all the companies in that index, pooling your money with other investors. The fund will mirror the weighting of the index.

However, index funds vary from other types of funds, both philosophically and strategically. Their strategy is to mimic the target index’s benchmark.

Index fund managers adjust their portfolio assets to stay as true to the index as possible. Therefore, fund returns should equal the performance of the specified index – before factoring in fund expenses.

Index funds offer a hands-free way to build and automate your route to wealth. And the lifestyle you dream of. They’re a simple way to start investing in the stock market today.

Passive Index Funds vs. Actively Managed Funds…

Which Is Right for You?

Index funds are the epitome of passive investments. There’s a strong case to be made for the virtues of passive funds over active funds… detailed in John Bogle’s The Little Book of Common Sense Investing.

Bogle introduced the first index fund back in 1976. His purpose was to give people a broad, cost-effective way to invest. No stock-picking knowledge or large bank accounts needed.

By contrast, managers of actively managed funds try to beat market indexes, not just match them. They pit themselves against an index, say the S&P 500. They’re considered successful if they beat that index.

Index Funds – Land of Low Fees (and Better Returns)

Obviously, an actively managed fund requires more fees. After all, they have to pay managers, analysts, tax advisors, and accountants. And pay for office space and advertising. Guess who ends up paying those costs? You do!

Managed funds typically charge fees of 1.0 to 2.5%. Whereas the fees on passively managed index funds can be as low as 0.01%. That’s a massive, Grand-Canyon-sized difference.

If actively managed funds could actually beat the S&P 500 routinely, and by a large enough margin to compensate for the fees, that’d be one thing. But historically they don’t.

Research over a 15-year period showed a dismal track record for actively managed funds.[i] A staggering 92% of large-cap, 95% of mid-cap, and 93% of small-cap fund managers did worse than their stated benchmarks.

Instead of earning 10% (the S&P average over the past 90 years), they might only achieve 8%… and then charge you 2%… Now your real returns drop to 6%. Not good.

This is where an index fund with their typical super-low fees really shines. You get almost every penny of the returns from your index fund. Which makes index funds and how they work a pretty sweet investment idea. 

An Index Fund for (Just About) Every Purpose

There are hundreds of indexes that measure various sectors of the stock market. The ones you’ll hear about most in the U.S. include:

  • The Dow Jones Industrial Average (DJIA, or “Dow”)
  • The Standard & Poor’s 500 (S&P 500)
  • The Nasdaq – a tech-heavy sector
  • The Russell 2000 – focuses on U.S small-cap stocks
  • MSCI EAFE – an index of international stocks from Europe, Australia, and the Far East (that’s the EAFE part)

There are also bond funds such as Barclays Capital U.S. Aggregate Bond Index Fund. And index funds that track specific sectors, such as airlines or tech.

Incidentally, there are also funds called “active index funds” which are a hybrid of passive and active management. They mostly follow an index. But they also allow the fund manager the freedom to buy or sell individual stocks.

If you’re a new investor and don’t want to commit tons of time to studying index funds and how they work, you might prefer to start with the S&P 500. Then you can branch out from there as you wish. 

What’s So Great About Index Funds and How They Work?

Their 9 Advantages…

Like all things in life, there are pros and cons to investing in index funds. Now that you know how index funds work, let’s talk about their benefits.

1. Instant diversification

What is an index fund and how does it work?

Index funds provide instant diversification of your investments… so you don’t have all your eggs in one basket.

It’s true that index funds won’t diversify your investments into areas like real estate, your own personal business, or gold and silver. But they’re a great way to diversify into all areas of stocks. Or bonds. Without the need to choose your own basket of individual stocks.

You can even get international diversification via funds like the MSCI EAFE fund. Or within sectors like energy, airlines, or tech.

2. Great for novice investors

You can get started investing today, and often with as little as $1. Nor do you don’t need a degree in stock-picking or thousands of dollars to do it. Once you know what an index is and choose your index, it’s simple to get started. Just open a brokerage account at a brokerage that offers the index fund you’re interested in. Index funds may also be available through your 401(k).

3. Simple to automate

As we’ve said many times, automating your finances is the best way to achieve your goals and dreams. Fortunately, index fund investing is easy to automate. As long as you’re content to take money from every paycheck to invest in the hypothetical XYZ Index Fund, automate it. You won’t miss the money you don’t see. And you’ll invest instead of save. (You’re welcome.)

4. Low time commitment, study, and decision fatigue

You don’t need to commit hours every week to studying stocks and choosing the one(s) you think will be the winners. The fund makes those decisions for you… so you can live your life. Besides, you can know almost nothing about investing and still be successful with index funds.

5. Stable returns

Over time, the S&P 500 has performed remarkably well, at about 10% per year on average. You’ll get about the same returns as the index your fund follows – minus the fund’s management costs (which should be minimal). For example, if you invest in an index fund tied to the S&P 500, you should get close to that 10% over the long haul. 

Since index funds track the index as a whole, they’ll never make outlandish returns like a high-flying stock might. They’re boring. But that’s just fine… especially as your investment base.

6. Low fees

An index fund’s portfolio rarely changes. As noted above, that means lower trading costs, management fees, and operating costs. There’s no need for analysts, researchers, portfolio managers, big offices, and high advertising costs. Do avoid any funds with 12b-1 maintenance fees.

7. Lower taxes

The fact that index funds are rarely traded minimizes the capital gains taxes that can come with a managed fund (outside of tax-advantaged retirement accounts).

8. Transparency

You can see what’s in the index fund at any point in time. This lets you assess risk. Managed funds may be more secretive about their holdings at any given point in time.

9. Easy to understand

Index funds are easy to understand. You should never invest in anything you don’t understand. Fortunately, index funds are a basket of stocks (see our article “What is a stock?”) that follow an index (see “What is an index?”). Simple, and no analysis needed… as long as you believe the market rises over the long haul.

Index Funds Have Disadvantages Too

Like all things in life, index funds aren’t perfect. Here are five disadvantages:

1. Inflexible

An index fund’s holdings are not up for debate. They only change when the underlying index changes. The fund manager cannot sell stocks that underperform the market.

2. Won’t beat the market

If you want to find that rare stock that blasts off to the stratosphere, you’ll be disappointed in an index fund. They are, by design, supposed to mirror the market. Not beat it.

You as an investor are sure to get the index’s return during market rallies. And you’re also sure to get the index’s loss when the market tanks.

What is an index fund and how does it work?

Index funds track the underlying index, both in gains and losses.

3. Risk of losing money

Any investment has the potential to lose money, as well as gain it. If the whole market tanks, or the index your fund tracks runs into trouble, you may lose money. Investing always involves the risk of loss of principal.

4. Tracking errors

A tracking error is the difference between the fund’s actual return and the return of the parent index. For index funds mimicking the same index, go for the one with the smallest tracking error.

5. Human managers

Humans are prone to error. A fund’s decision-makers may not always be 100% transparent. They may not be tightly regulated. And they may also have conflicts of interest.

Are Index Funds Right for You?

Still need help deciding if an index fund is for you? How many of these questions can you answer “yes” to?

1. Do you have a long investing horizon? Will it be a long time till you need this money? Index funds are best for those with a long investing horizon.

2. Do you want a simple diversified base on which to build a strong investment portfolio? Even if you later choose to add individual stocks, index funds can be a no-brainer for at least 25% to 30% of your total portfolio.

3. Do you want a portfolio that’s sleep-at-night-boring? Are you willing to find excitement in other places than the stock market? If so, index funds might be for you.

4. Are you comfortable with modest gains – at least for this portion of your stock portfolio? You won’t get shooting star results in an index fund.

5. Are you the buy-and-hold type? Index funds are basic buy-and-hold investments. Nothing flashy. If you’re into trading all the time, index funds won’t be your cup of tea. But even then, you could form a portfolio base with boring buy-and-holds, and then build out your trading from there.

How to Choose an Index Fund

Before you choose any investment, always read the fund’s prospectus. It contains important information about that fund. I know, I know… it’s fall-asleep boring. But it’s important. And if you choose wisely and automate your investments, you’ll only need to do this once (unless they notify you of changes).

Consider these factors:

  • How much risk are you willing to take? Sector index funds might be riskier than the S&P 500, because sectors are cyclical.
  • How much will you owe them for buying, holding, and selling the fund? Compare with other funds that mimic the same sector.
  • Time horizon. When will you need this money? Always have your time horizon in view when you’re investing.

Are Index Funds a Good Investment?

As stated above, passive index funds tend to outperform actively-managed funds. As such, index funds can be very good investments. Especially for building a solid base before you venture out into other types of investments. Remember to read the prospectus before buying any investment.

This article is for informational purposes only. It is not to be construed as individual investment advice. You should always evaluate your particular situation and make smart decisions for yourself.




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