An index fund is a type of mutual fund that mirrors the performance seen in a specific market, like S&P 500. Due to the fact that it runs in tandem with the market, investors new to the world of finance can enjoy passive investment strategies while watching their funds grow. Investors also gain from the added advantages of lower cost ratios (as they do not require a fund manager) and the stability that comes with index funds. Historically, index funds perform quite well and due to this, they can be considered low-risk investments, making them quite ideal for new investors who want to gain their footing in the world of investing before venturing towards riskier moves.
One of the most vital things about index funds that one must keep in mind is the fact that these investments are meant to be treated as long-term strategies. Investors must apply a buy and hold strategy in order to truly profit from index funds. If you are interested in a more active approach of investing that involves the buying and selling of stocks as per daily market trends, then this investment may not be the right avenue for you. However, if you want a stable investment that yields good returns without subjecting your funds to any risks, then you must certainly consider index funds.
Investing in Index Funds Instead of Individual Stocks
An individual stock that belongs to a company can offer great dividends over a long period. However, the value of your earnings correspond directly with the single stock you own. Index funds, on the other hand, are made up of multiple stocks and buying a single share of an index fund means that you own parts of all the shares in that specific fund. As a result, you can enjoy greater diversification in your portfolio.
Furthermore, when you invest in an index fund over individual stocks, you stand to gain another crucial benefit – these funds recover at a faster rate than individual stocks do, when it comes to ups and downs in the market. For instance, let’s say an index fund tracking S&P 500 lost 34% in 2008. The same fund would have seen a staggering increase by 350% right at the beginning of 2018. Having said that, it is essential to note that such recoveries only happen if you are willing to invest your funds for a long time. Short term investments (anything under 5 years) may not yield the same kinds of results.
Of course, while it is not prudent to assume that the stock market will always recover, investors can gain comfort from the fact that historically, it has always recovered. Such stock market behavioural trends do add a certain layer of security in one’s mind while investing in index funds. If you are looking for a ‘safest’ way to invest in the market, then choosing indexes that have withstood the test of time, like S&P 500 and Dow and Jones Industrial Average, is a good way to go.
Investing in Indexes Which Track Specific Sectors
While investing in indexes that track the stock market is a good move for novice investors, one can also invest in indexes that tract sectors to ensure further diversification of the portfolio. A few examples of sectors that you can track include oil, consumer goods, technology, finance, and so on. The biggest advantage of investing in multiple sectors is that even if one does not perform as expected, another sector may yield profits. This way, you can cushion yourself from any losses or financial blows.
A crucial aspect to keep in mind while investing in indexes that track sectors is that you should not duplicate any elements in your portfolio. For instance, if you are planning to invest in oil, some of your stocks within the energy sector may end up being a duplication of the same.
Choosing the sector that you want to invest in can leave you with decision fatigue, however, ensuring that you always keep your financial goals in mind while choosing these sectors can help you make decisions that reflect your goals. If you are unsure about how to go about it, speaking with a financial advisor can help you gain the clarity you crave.
The Difference Between an ETF and Index Fund
An Exchange Traded Fund (ETF) tracks a market sector, commodity or an index. They offer high liquidity as they are traded in the same way that stocks are. They can also be bought and sold at any given time during market hours. ETFs are a type of investment you can make if you want to invest in an index fund. However, not all index funds are ETFs. Mutual funds are also a type of fund that track indexes.
When choosing your investment, it is crucial to understand the type of fund you are investing in. If you want to know more about ETFs, have a look at our previous article that outlines everything you need to know about the same!