Beginner’s Guide to Investing in Index Funds

What are Index Funds?

Index funds are a type of mutual fund or exchange-traded fund (ETF) that contains stocks or bonds that replicate a specific index. They can be a great investment for beginners, but it’s important to understand how to choose the right fund, as well as the pros and cons.

Examples of Index Funds

Thousands of indices track sector and market movements daily. They are used to measure market health and performance. The Dow Jones Industrial Average is a broad market index consisting of 30 major stocks. The U.S. Global Jets Index tracks the global airline sector as a sector index. An index can also serve as a market benchmark or a means of evaluating performance.

Here are some examples of index funds and what each tracks:

• Vanguard 500 Index Fund (VFIAX): 500 of the largest companies in the United States.
• iShares Russell 2000 ETF (IWM): 2000 small-cap stocks in the United States.
• Fidelity Sustainability Bond Index Fund (FNDSX): Bonds that meet environmental, social, and governance standards.
• Global X Millennials Thematic ETF (MILN): U.S. companies that benefit from millennial spending habits.
• Direxion Work From Home ETF (WFH): U.S. companies that benefit from working from home.

How to Choose an Index Fund

Investors should read all available information about the fund, especially its brochure.

Define Your Goal

You should evaluate several factors before purchasing an index fund. First, determine what you want to invest in and why. What are the risks associated with this investment? How much risk are you willing to take to achieve this goal?

Research Available Options

For most indices you wish to invest in, you will find several mutual funds and ETFs that offer the same exposure. You don’t need to choose the first index fund you come across, and you should compare the available options. Compare transaction costs for funds that cover the same sector. How much will you pay to buy, hold, and sell the fund?

Determine How to Buy the Index Fund

If you don’t plan your entry strategy properly for your investment, you risk losing money unnecessarily. Instead of buying immediately when you know you want to invest in something, think about how you can be more strategic. For many, this means using dollar-cost averaging strategies that remove emotion from such decisions. Others may use technical analysis to develop a buying strategy.

Advantages and Disadvantages of Index Funds

Advantages of Index Funds

• Reliable Performance: You should receive the same return as the index, minus the fund’s management costs, if you invest here. Index funds typically yield better returns than actively managed funds in most cases.
• Lower Costs: The portfolio of an index fund rarely changes. This stability results in lower trading costs and taxes. Fund operating costs are reduced since there’s no need to hire portfolio managers or stock researchers, or pay commissions resulting from ongoing trading. Active fund costs are around 1.3%, or $1.30 for every $100 in the fund.
• Transparency: Many index funds maintain what is in the index, so you can always see what the fund contains. This allows you to assess the risks associated with the index fund based on those assets. An index fund tracking the volatile oil and gas sector may pose a much greater risk than a bond index fund.
• Simple Diversification: You can buy slices of hundreds or thousands of companies at once instead of individual stocks as you try to build your portfolio. This diversification reduces risk. If one stock or bond is down for the day or year, it’s likely that another asset is on the rise.

Disadvantages

Index Funds

• Lack of Flexibility: The fund typically retains the same securities regardless of market direction since its goal is to track the index. The fund manager cannot sell underperforming stocks, especially during a broad market downturn.
• Inability to Outperform: This lack of flexibility means that index funds are unlikely to achieve higher returns than the index. You are guaranteed the return of the index when the market (or sector) rises, but you are also guaranteed to lose with the index when the market declines.
• Tracking Error: The difference between the return of the index fund and the performance of the original index reflects the costs associated with managing the portfolio. This is referred to as “tracking error.” Always choose those with lower tracking error when comparing index funds that track the same index.
• Management Differences: Indexes are not objective. They are created by companies that determine the index’s composition. The decision-making process is not strongly regulated. It is not always transparent and can be influenced by general management tactics. Sometimes, index funds and the index may have the same managers, which can create conflicts.

Why Index Funds Might Be Good for You

If you are looking to diversify your investments, an index fund offers a simple solution. When someone wants to buy stocks but isn’t sure exactly which stocks to buy, they can use a broad market index fund to gain general exposure to stocks in one transaction.

Index funds can also be used to adjust your portfolio’s exposure without selling anything you currently own. For example, if you own an S&P 500 index fund but don’t think the index holds enough healthcare stocks, you could buy a healthcare ETF to increase your exposure to that sector. Conversely, if you believe the S&P 500 has too many healthcare stocks, you could use a short healthcare ETF to gain short exposure to that sector.

Why Index Funds Might Not Be Good for You

Some investors seek exposure to the stock market, while others aim to outperform the market. If your goal is to earn more money than the average investor, you cannot use funds that replicate the average performance of the index you’re trying to outperform.

There are other advantages to investing directly in individual stocks or bonds. Owning stocks gives you voting rights, and you will receive dividend payouts directly from the company rather than receiving the average payout across the entire sector. Individual bonds have a maturity date that tells you when your principal will be redeemed, while bond funds continuously invest in rolling over maturing bonds into new bonds.

Frequently Asked Questions (FAQs)

How can you invest in index funds?

You will need a brokerage account or retirement account to invest directly in index funds. Once you have a means to invest, you can place a buy order for an ETF or mutual fund that tracks your target index.

How many index funds should I own?

The number of index funds you should own depends on how diverse those indexes are. If you invest in well-diversified funds, you may only need one or two funds. If you are investing in targeted funds that track specific sectors, you should own multiple funds to build a broad and diverse portfolio. You can also put most of your money into one good diversified fund and allocate a small amount for different targeted investments.

How much money do you need to invest in index funds?

You can start investing in index funds with a very small amount, but it is unwise to invest more than you can afford, especially if you do not have emergency savings.

Source:

https://www.thebalancemoney.com/investing-in-index-funds-for-beginners-356318