Everything You Need To Know About Index Funds

Ready to start investing and wondering how to go about doing it? You should consider using index funds. When I started investing, the thought of picking each individual stock terrified me. Where do I start? How do I know which stocks to pick? How do I avoid making mistakes? These were some of the questions that I grappled with. It wasn’t until I learned about index funds and that understood that there is a safer and less risky way of investing. To start, what exactly are index funds?

What is an index fund?

In short, an index measures the performance of a large group of assets of a similar type, such as stocks, bonds, currencies or commodities.

Indexes factor together the prices of a wide range of assets, making it easier to track their performance.

For example, the S&P 500 is an equity index that consolidates the stock prices of 500 of the largest publicly traded U.S. companies. The S&P 500 makes it easy to understand whether the leading U.S. stocks are gaining or declining in value. There are many other stock market indexes such as FTSE 100 index (companies listed on the London Stock Exchange), the DAX (30 major German companies), the STOXX Europe 600 (companies across 17 European countries).

An index fund would track the performance of one of these market indexes. They’re a form of passive investing, because they allow investors to buy a lot of assets at once and hold them for the long term.

The good thing about indexes is that there’s probably one for every asset class and almost every economy sector. They can track the performance of stocks, bonds, every kind of commodity and foreign currencies. The list goes on and on.

Index Funds Are All-In One Investments

Personally, my favorite thing about index funds is that they’re designed to be simple, all-in-one investments.

When you invest in an index fund, you’re not picking stocks you think will do better than the market. Instead, what you’re doing is you own all the stocks in a certain market index, like the S&P 500. The reason behind this isn’t that you’ll beat the market, rather, it’s that you’ll keep up with it.

And considering that the stock market has averaged 10% annual return over the past 90 years, this thinking often pays off.

Warren Buffet Recommends Investing in Index Funds

In fact, Warren Buffet loves index funds so much that he recommends that most people just buy a low-cost index fund and hold onto it for a long period of time.

If you don’t have enough knowledge about picking individual stocks, using an index fund is truly a solid way to take advantage of the success of major companies without worrying about the risks of buying individual stocks.

Why? While individual stock prices can fluctuate wildly, the broader index tends to go up over time — and with index funds, you don’t have to pick the winning stocks to benefit from the market’s overall gains.

Super Low Fees

Index funds offer a very cost-effective way of investing. Fees matter because they can cut into your overall return. For example, the average expense ratio for index fund was 0.08% for 2018, compared to 0.76% for actively managed funds. That works out to $0.70 for every $1,000 invested versus $7.60.

Simple Way to Diversify

Another great benefit of index funds is diversification, which helps to minimize your portfolio’s related risk. Because money is spread out across a variety of assets rather than just a handful of individual stocks, your portfolio is less likely to see sharp, short-term fluctuations. Similarly, by you investing in a broad range of assets, you minimize the chances of you losing a lot of money if you invest in just a handful of stocks.

For example, an index like the S&P 500 typically moves up or down less than 1% on any given day.

How to invest in index funds

When investing in index funds for the first time, you may not know where to begin. Consider using these steps as a guide for purchasing your first index fund:

• Pick the right brokerage. There are many financial firms that offer index funds. You want to do a lot of research before picking one and want to make sure that the company has a long history of providing these services.  Vanguard, Fidelity, Betterment, Wealthfront, Ellevest and Charles Schwab are just some of the wealth management companies that offer index funds.
• Know what you’re tracking. Be sure you understand what index a particular fund is tracking — and what stocks (or other assets) are included in that index. Many indexes have similar names, even if they look nothing alike.
• Do you have fund overlap? You don’t need a lot of index funds to achieve diversification, even a handful of funds can do the trick. That’s why you need to pay attention to what indexes you’re tracking to ensure you aren’t loaded with near identical funds.
• What are your investing goals? Next, have you thought about what you’d like to accomplish with your portfolio? Are you investing for a down payment on your house, college, retirement? Knowing what you’re investing for can help with choosing index funds are that suited for your needs.
• Check the fees. While index funds are typically low cost, the associated administrative fees can still vary widely fund-to-fund. Pay attention to expense ratios and prioritize funds with lower fees.

Remember that you don’t have to be an expert investor to be successful, index funds can be a low cost and easy way to diversify your portfolio.