Index funds are mutual funds or exchange-traded funds that track the returns of a market index, such as tracking the S&P 500.
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What are index funds?
An index fund is a collection of stocks or bonds that mimic a market index, such as the S&P 500, Dow Jones Industrial Average, Russell 2000 Index, and Nasdaq Composite.
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The reason you’d invest in an index fund is because you can’t invest in a market index.
For example, the S&P 500 is a market index that tracks large-cap companies across different industry sectors. It’s considered a good way to measure and track the overall health of the U.S. stock market.
You can’t buy shares of the S&P 500 market index because it’s not an actual fund. It’s just a measurement of the stock market.
Therefore, you have two options. You can either buy 500 individual stocks or shares of an index fund that mimics the performance of the S&P 500.
An index fund is a low-cost investment that immediately diversifies your portfolio and allows you to invest in many companies without paying full price for each one.
It’s also considered a passive investing strategy, which means you don’t buy and sell frequently. Instead, it’s a buy-and-hold method focused on long-term results.
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John Bogle, founder of Vanguard says, “The index fund is a sensible, serviceable method for obtaining the market’s rate of return with absolutely no effort and minimal expense. Index funds eliminate the risks of individual stocks, market sectors, and manager selection, leaving only stock market risk.”
Benefits and drawbacks
Regardless of what type of investor you are, index funds are essential for long-term gains. Warren Buffett, CEO of Berkshire Hathaway, states that it’s beneficial for large and small investors.
He says, “When trillions of dollars are managed by Wall Streeters charging high fees, it will usually be the manager who reaps outsized profits, not the clients. Both large and small investors should stick with low-cost index funds.”
The following are benefits of investing in an index fund:
- Lower costs.
- Low maintenance.
- Instant diversification.
- Solid returns.
- Outperform most of the actively managed funds.
An index fund is an excellent investment that offers long-term gains. Like any other investment, there are risks associated with it. The following are several drawbacks:
- You won’t beat the market because they’re designed to mimic the market index.
- You don’t have control over the stocks you own.
- It’s not meant for short-term investing.
- Underperformance is a possibility.
How to invest in an index fund
Take the following steps to invest in an index fund:
- Choose a brokerage that offers index funds.
- Select several index funds to compare.
- Compare the investment minimums, risks, fees, investment strategies, and stocks that make up the fund.
- Select a fund and invest regularly.
Note: Before you invest, read the prospectus and other available information about the investment.
The overall process of investing in index funds is simple. However, choosing the right fund is the most important part.
When you’re choosing a fund, make sure you choose a good and established brokerage. Common options include Fidelity, Vanguard, Charles Schwab, and BlackRock.
You’ll also want to understand what your investing goals are. This will help you establish a plan for contributions, and the time-frame that you’d like to invest.
The expense ratio is another important factor. If there’s a fund that has an expense ratio that’s greater than 1%, avoid it. That means 1% of the assets are going to administrative, management, advertising, and other expenses.
Ideally, choose a fund that has an expense ratio that’s less than 0.05%.
The following are examples of index funds that you can invest in:
- Fidelity ZEROSM Large Cap Index Fund (FNILX)
- Tracks large-cap companies in the Fidelity U.S. Large Cap Index.
- 0.00% expense ratio.
- Vanguard 500 Index Fund Admiral Shares (VFIAX)
- Tracks the 500 largest companies in the U.S.
- 0.04% expense ratio.
- iShares Russell 2000 ETF (IWM)
- Tracks the 2,000 small-cap companies in the Russell 2,000 index.
- 0.19% expense ratio.
- Schwab International Index Fund (SWISX)
- Tracks the total return of large, publicly-traded non-U.S. companies.
- 0.06% expense ratio.
Frequently asked questions
Yes, an index fund is an excellent investment because it’s low-cost and mimics a market index.
If all of the companies go bankrupt, then yes, you can lose all of your money. However, the chances are very slim because index funds are diversified with low operating costs and portfolio turnover.
With consistent contributions and time, you can become wealthy. However, if you only invest a small amount and never touch it again, then you won’t.
Index funds are easy to invest in, don’t require frequent trading, and instantly diversifies your portfolio. With a long-term mindset and consistent contributions, you can build wealth and see excellent results.
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About David Em
David Em is the founder of More Money More Choices, which he launched to help you take control of your finances and build your dream life. Before More Money More Choices, David worked in leadership positions in the finance industry.