The concept of index funds was first created during the 1970s and has since made a huge impact on the world of finance. In this article, we will explain what index funds actually are, what benefits you can expect by investing in them as well as what potential drawbacks may exist.
After reading this article you will be able to decide if you want to invest in an index fund or not. Without further ado, let’s get to the thick of it.
What Is an Index?
Before we delve into the explanation of the index funds, we need to provide you with a brief summary of what an index is.
The interesting thing about an index is that it is more of an academic concept than a tangible, real-world one. Basically, an index consists of a group of people considering how to build a portfolio of individual funds. The most famous index is the Dow Jones Industrial Average, which contains a list of thirty blue chips dating back to 1928. The stocks are shortlisted by the Wall Street Journal editors.
S&P 500 is one of the top seven stock market indexes in the United States. Dow Jones Industrial has started it in 1957, making it the world’s most influential index ever since.
What Is an Index Fund?
Index funds’ purpose is to purchase all the stocks in the same proportion as in a particular index. What this means is that the index fund is nothing more than a mutual fund that chooses how to expand our portfolio by following the methodology of a particular index. This is different from the regular mutual funds that have a portfolio manager who makes all the decisions about capital allocation.
This means that if your index fund is following the Dow Jones industrial average index fund, you let the WSJ editors control where your money goes while keeping the ownership of your portfolio.
In summary, index funds mimic and copy the actions of a market index.
What Are the Advantages of Investing in Index Funds?
First and foremost, index funds are extremely useful for investors that have limited budgets.
We have compiled a list of their biggest advantages:
- By choosing an adequate asset management company, we can participate in any underlying market with a single purchase. This, in turn, allows us to pay low transaction costs.
- Index funds have a tendency to operate on equity markets in a way that minimizes turnover. For a long time, this has been crucial in maximizing investment effects.
- Out of all the mutual funds, index funds have by far the lowest expenses. This is especially useful for those of us with modest portfolios.
- If we are not good at math, we should definitely consider using index funds. This way, we can avoid getting ourselves and our families into bad financial states due to our poor finance skills. Index funds help by hiding the return of underlying components, relieving investors from having to think about them.
- Those of us who can’t value businesses can rely on index funds because they can prevent us from falling into the temptation of selecting individual ownership stakes in different enterprises.
The median participating balance for a retirement account is only 29,603$. This sum won’t even cover the minimum fees in most portfolio management groups. We wouldn’t even be able to be serviced at most regional bank trust departments. Most of these departments charge investment management fees anywhere up to 3%. This fee isn’t worth it if we take into account that banks will underperform compared to the index.
For those of us who are entering the golden years, index funds can be very useful.
What About the Downsides?
Every downside to investing in index funds will be more obvious the more successful you become. Remember, index funds are not a perfect copy of any market index.
The most successful investors have always been the ones who kept the costs low while at the same time combining diversified equity ownership with long ownership periods. They had to do that due to the low turnover. This was the only way for small-time investors to make a profit. We have an alternative now.
Index funds are a form of passive income. If we don’t like how our money is being used, there is no way to remove it from the fund, without exiting it completely.
Most of the index funds are not solid representatives of most sectors and industries.
Get Started Today
Index funds come with both upsides and downsides. If you have a modest portfolio with no idea what to do with it, you should consider investing in an index fund. Also, index funds are a good choice for investing your 401k.
All in all, if you find yourself in the demographic for which the Index funds are the best choice, then go for it.