What are Index Funds?
Index funds are lists of stocks selected by experienced investors based on their performance, reliability, and longevity. There are many indices, but the most well-known are the Standard & Poor’s 500 and the Dow Jones Industrial Average.
Daily, weekly, monthly, and annual stock prices are monitored on these indices and compared. This is the number you might see in daily stock news if they talk about the rise or fall of one of the indices.
Another popular index is the Russell 2000. This index is a list of companies with small market capitalizations that attract investors interested in investing in small businesses.
What are Passively Managed Index Funds?
If fund managers are constantly changing underlying investments and reallocating capital, the fund is considered actively managed. Passive funds are built more around a stock index. These funds only change intermittently. If a stock is removed from the index and replaced, fund managers will do the same.
A passively managed index fund is a fund based on an index that does not follow the latest trends; rather, fund managers ensure that the underlying investments are always from the index they track.
Important: Not all passively managed funds are index funds. However, index funds are almost always passively managed.
Risks of Passively Managed Index Funds
In the short term, stock prices (as measured by stock market indices) can experience sharp fluctuations both upward and downward. Such significant volatility is considered a common risk in investing. Even passively managed index funds come with the risk of financial loss.
The potential for an investment to lose value is the fundamental notion of risk. When you buy a stock, you do not know whether it will gain value or lose value. Passively managed index funds are designed to minimize the amount of risk the investor takes on. This is because they track or invest in stocks that have been chosen and placed in an index by informed investors and professionals in finance and business.
Minimizing risk does not mean there is no risk. Passively managed index funds can lose value in market fluctuations.
Investing in Passively Managed Index Funds
Investors often view index funds as long-term investments with lower risks based on the historical performance of the underlying assets. Some investors believe that long-term investing is riskier than short-term investing, while others believe the opposite. Some prefer to mix both strategies.
Note: Passively managed index funds are generally designed for long-term investing.
Many financial advisors or experienced investors suggest taking more risks when younger because you have more time to recover from any losses. As you get older, they advise reducing risk. These beliefs lead to five core concerns about investment strategies:
- Long-term investing may be risky.
- Short-term investing may be risky.
- Mixing short-term and long-term strategies.
- High risk is better when younger.
- Low risk is better when older.
How can you address these concerns using a passively managed index fund? You can create a portfolio of several index funds that address each issue. If you are on the younger side, for example, let’s look at how to invest passively and allocate a portfolio made up of 100% stocks across different index funds. This is also known as asset allocation. Your mix could be as follows:
- 30% S&P 500 Index Fund: Low risk
- 10% Mid-cap Index Fund: High risk
- 10% Russell 2000 or Small-cap Index Fund: Higher risk
- 20% International Large-cap Index Fund: Low risk
- 10%
- Emerging markets index fund: Higher risk
- 10% International small-cap index fund: Lower risk
- 10% Real estate index fund: High risk
Bonds such as U.S. Treasuries or corporate bonds are typically considered low-risk investments. There are also bond index funds. As you age, you may want to decrease your allocation to stock index funds and increase your allocation to bond index funds. This can reduce the amount of risk in your portfolio and preserve its overall value.
What is the ideal asset allocation mix for you?
You may often hear that you should take on more risk when you’re young because you have more time to recover from losses. In this case, your asset allocation mix is being discussed. One of the simplest ways to determine how to allocate your portfolio’s assets is the 100 minus age technique. You subtract your age from 100. Then use the result as the percentage of stocks you should have in your portfolio.
Some have adjusted this technique to 110 or 120 minus age. This can help increase risk and returns when you’re young, and it can also increase returns when you’re older and your portfolio has shifted more to bonds instead of stocks.
Another theory that can help you allocate your assets is the modern portfolio theory. This theory uses standard deviation analysis to minimize risk and maximize returns.
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Sources:
FTSE Russell. “The Russell 2000 Index: Small Cap Index of Choice.”
Source: https://www.thebalancemoney.com/passive-investing-and-index-funds-2388593
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