A passive investment method achieved by investing in an index fund
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What is Index Investing?
Index investing is a passive investment method achieved by investing in an index fund. An index fund is a fund that seeks to generate returns from the broader market by tracking an index. The S&P 500 is the most popular index to track, with a historical annual return of 10%.
Summary
- Index investing is a passive investment method achieved by investing in an index fund.
- The benefits of index investing include low cost, requires little financial knowledge, convenience, and provides diversification.
- Disadvantages include the lack of downside protection, no choice in index composition, and it cannot beat the market (by definition).
- To index invest, find an index, find a fund tracking that index, and then find a broker to buy shares in that fund.
Understanding Index Investing
Index investing falls under passive investing, which involves a buy-and-hold strategy for the long term. On the other hand, active investing is concerned with frequent buying and selling, coupled with continual monitoring of performance.
Exchange-traded funds (ETFs) are the security of choice when index investing. It is because ETFs are passively managed, and therefore low cost – the perfect medium for an index fund.
Advantages of Index Investing
Warren Buffet once said, “A low-cost index fund is the most sensible equity investment for the great majority of investors,” and it’s clear to see why.
- Low cost: Because index funds take a passive approach tracking an index, it has lower management fees than an actively managed fund
- Requires little financial knowledge: Index investing is relatively easy compared to building your own portfolio
- Convenience: Index funds contain hundreds of stocks that would be incredibly hard to replicate at an individual level
- Diversification: Holding a large array of stocks diversifies away idiosyncratic (firm-specific) risk
Disadvantages of Index Investing
- Lack of downside protection: There is no floor to losses
- No choice in the index fund’s composition: Cannot add or remove any holdings
- Can’t beat the market: Can only achieve market returns (generally)
How to Start Index Investing
Step 1
The first step to index investing is choosing the right index for your preferences. As mentioned, a common index to track is the S&P 500, an index composed of 500 large U.S. companies. Other popular indexes include the Dow Jones Industrial Average (DJIA), a composite of 30 US large-cap companies, and the NASDAQ Composite, another U.S.-based index that is heavily weighted in the IT sector. The U.S. market is often used synonymously as the broad market because of its importance and influence as a financial hub.
For individuals with more advanced financial knowledge, index investing can be a very useful tool to potentially “beat the market.” If you expect a particular region, sector, or factor to outperform, you can choose to invest in an index that specializes in such areas. For example, if you expect Asia to outperform in the future, you may look into tracking an Asian index. Popular indexes include:
- Shanghai SE Composite Index (China)
- Hang Seng Index (Hong Kong)
- Nikkei 225 (Japan)
The stock market is comprised of 11 sectors, formally known as the Global Industry Classification Standard (GICS). Such sectors include IT, healthcare, consumer discretionary, energy, industrials, and more. There are many available sector indexes that can be benchmarked.
Lastly, a factor is an attribute that’s been historically proven to provide excess returns across assets. Some identified factors include:
- Value
- Size
- Quality
- Momentum
- Volatility
- Growth
Each factor performs well at different points in the business cycle. If you feel confident of any specific factor, you can target it by buying into a factor index.
Of course, it should be noted that investing in a specific area will increase your risk. It is because if you choose to go overweight in a specific region/sector/factor and it ends up doing poorly, all your investments will suffer as a result. Nevertheless, higher risk comes with a higher return, so if you bet on a specific area that performs favorably, you can beat the broad market.
Step 2
The second step is to choose a fund that tracks such an index. There are many ETF providers that will have similar offerings with slight variations, so it is wise to do research into the differences. Such differences could be the expense ratio, dividend yield, performance, and more.
Step 3
The last step is to buy shares from your chosen index fund. To do so, you must open an account through a broker. Again, every broker may offer different benefits and drawbacks, so it is important to compare before jumping in.
More Resources
CFI is the official provider of the Capital Markets & Securities Analyst (CMSA)® certification program, designed to transform anyone into a world-class financial analyst.
In order to help you become a world-class financial analyst and advance your career to your fullest potential, these additional resources will be very helpful:
FAQs
Over the long term, index funds have generally outperformed other types of mutual funds. Other benefits of index funds include low fees, tax advantages (they generate less taxable income), and low risk (since they're highly diversified).
Does index investing really work? ›
Index funds can be an excellent option for beginners stepping into the investment world. They are a simple, cost-effective way to hold a broad range of stocks or bonds that mimic a specific benchmark index, meaning they are diversified.
Is it OK to only invest in index funds? ›
If you're new to investing, you can absolutely start off by buying index funds alone as you learn more about how to choose the right stocks. But as your knowledge grows, you may want to branch out and add different companies to your portfolio that you feel align well with your personal risk tolerance and goals.
Is it hard to beat index funds? ›
Long-term investors have been well served by index funds, which often charge very low fees and can be hard for active portfolio managers to beat. But some investors want to select individual stocks for portions of their portfolios.
Why doesn't everyone just invest in S&P 500? ›
That's because your investment gives you access to the broad stock market. Meanwhile, if you only invest in S&P 500 ETFs, you won't beat the broad market. Rather, you can expect your portfolio's performance to be in line with that of the broad market. But that's not necessarily a bad thing.
Do billionaires invest in index funds? ›
It's easy to see why S&P 500 index funds are so popular with the billionaire investor class. The S&P 500 has a long history of delivering strong returns, averaging 9% annually over 150 years. In other words, it's hard to find an investment with a better track record than the U.S. stock market.
Do index funds ever lose money? ›
As with all investments, it is possible to lose money in an index fund, but if you invest in an index fund and hold it over the long-term, it is likely that your investment will increase in value over time.
Is there a downside to index funds? ›
While indexes may be low cost and diversified, they prevent seizing opportunities elsewhere. Moreover, indexes do not provide protection from market corrections and crashes when an investor has a lot of exposure to stock index funds.
Are index funds 100% safe? ›
Because the goal of index funds is to mirror the same holdings of whatever index they track, they are naturally diversified and thus hold a lower risk than individual stock holdings. Market indexes tend to have a good track record, too.
Why don t more people invest in index funds? ›
Another reason some investors don't invest in index funds is that they may have a preference for investing in a particular industry or sector. Index funds are designed to provide exposure to broad market indices, which may not align with an investor's specific interests or values.
Investing in an S&P 500 fund can instantly diversify your portfolio and is generally considered less risky. S&P 500 index funds or ETFs will track the performance of the S&P 500, which means when the S&P 500 does well, your investment will, too. (The opposite is also true, of course.)
Is it smart to only invest in the S&P 500? ›
For investors who want to get in on the action, the good news is that investing in a fund that tracks the S&P 500 index is an easily accessible strategy. But experts say it also deserves a word of caution: Past performance is not indicative of future returns.
Can index funds make you a millionaire? ›
For example, if you are able to commit to investing $500 a month in an S&P 500 index fund like the Vanguard 500 Fund (NYSEMKT: VOO), you'll eventually have $1 million, and that includes paying the 0.03% expense ratio in the ETF, meaning you'll pay 3 cents each year for every $100 you have invested in the index fund.
Can you live off index funds? ›
Once you have $1 million in assets, you can look seriously at living entirely off the returns of a portfolio. After all, the S&P 500 alone averages 10% returns per year. Setting aside taxes and down-year investment portfolio management, a $1 million index fund could provide $100,000 annually.
Is there anything better than index funds? ›
Exchange-traded funds (ETFs) and index funds are similar in many ways but ETFs are considered to be more convenient to enter or exit. They can be traded more easily than index funds and traditional mutual funds, similar to how common stocks are traded on a stock exchange.
What are 2 cons to investing in index funds? ›
The benefits of index investing include low cost, requires little financial knowledge, convenience, and provides diversification. Disadvantages include the lack of downside protection, no choice in index composition, and it cannot beat the market (by definition).
How much of my income should I invest in index funds? ›
Investing 15% of your income is generally a good rule of thumb to meet your long-term goals. Even if you can't afford to invest that much today, you can still start investing with what you can afford. Your investment amount may fluctuate as your cash flow changes, but staying consistent can pay off in the long run.
Is it better to buy individual stocks or index funds? ›
Investing most or all your money in individual stocks is risky and can lead to losing your investment capital. Investing exclusively in index funds is risk averse and offers much less in the way of returns. Ideally, you want to keep most of your investment dollars in safer investments such as index funds.
