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Investing in INDEX FUNDS

Warren Buffet, one of the world’s most successful investors, acknowledges that stock picking doesn’t work for everybody and recommends: investing in low-cost index funds. Further, he says that index funds are, “the most sensible equity investment for most average and long term investors.”

What is an index fund?

An index fund is a group of investments that you put your money into and get a percentage of the entire thing as a single investment. It’s a type of mutual fund consisting of stocks, bonds, commodities, and other assets. The three major stock indices are Dow Jones, S&P 500, and Nasdaq.

Index funds track the performance of a market index. Their sole purpose is to match the market rather than beating the market.

You might have invested in index funds without knowing it. They are the most common type of investment option to choose from in most 401(k) plans.

Benefits of investing in Index Funds

Low costs

Index funds are a form of passive investing. Passive investing means that index funds don’t have fund/portfolio managers actively strategizing and selecting which stocks to include in the fund.

On the contrary, actively managed funds have high costs since there are people researching and choosing the stocks to include in your portfolio.

Additionally, index funds replicate the performance of a benchmark index, and therefore, don’t need research or stock selection. Because of the low costs involved, the returns are much higher.

Broad diversification

With an index fund, you’re investing in hundreds and thousands of stocks. Conversely, you automatically have a diversified portfolio than investing in single stocks. Therefore, reducing the chance of losing money since your money is spread out across different assets.

For instance; if you buy 10 individual stocks and one of them performs poorly, it could have a big impact on your portfolio. But if you invest in… say the S&P 500 which is a stock market index that tracks the performance of the 500 largest publicly traded US companies, you’re buying a small percentage of all these companies. Therefore, your money is spread out among so many different stocks.

Tax advantage

Since they are passively managed, index funds have very low turnover. This means the trading in and out of securities are not frequent. Therefore, they generate fewer capital gains distributions that are passed on to the shareholders.

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Drawbacks of index funds

There are a few risks associated with index funds:

Low flexibility: since you’re investing in certain indexes you cannot choose the companies to invest in. So, if there is a company you would wish to avoid, you either avoid that fund or invest in all the companies in the fund.

No downside protection: the stock market is a game of ups and downs. Index funds give you an upside when the market is performing well but will leave you vulnerable in case of a market crash. On the other hand, with an actively managed fund the managers might sense an unfavorable situation and adjust your portfolio’s position protecting you from the downside.

How to invest in Index funds

There are three steps involved:

  1. Pick your index

There are so many other indexes you can track using index funds. You can choose depending on:

  • Company size. Do you want to track stocks from large, mid-size or small cap companies
  • International index funds. Do you want exposure to companies abroad?
  • Asset type: Stocks, domestic and international bonds, commodities, etc.
  • Do you want indexes that are tied to specific industries such as real estate, technology, etc?

It is extremely important to understand the index you’re tracking.

  1. Choose the corresponding index funds

Once you select the index you’re interested in, you can find at least one index fund that tracks it. Sometimes you have more than one fund for your index.

In such a situation, you have to consider some factors

  • Low cost
  • Minimum investment amount
  • Expense ratio. This is the fee you pay the brokerage to manage your investment. Its advisable to look for a fund with an expense ratio of 0.5% or low. Example, if you invest in an index fund with a 0.5% expense ratio means the brokerage will keep $5 for every $1000 you invest.
  1. Purchase your index fund

You can buy index funds directly from a mutual funds provider such as Vanguard or through a brokerage account such as Robinhood. When choosing where to buy, consider different features and costs such as fund selection, trading costs, commission-free options, and convenience.

SHOULD YOU INVEST IN INDEX FUNDS?

Index funds offer you an easy, low cost, and more diversified way to invest. It’s an investment option that is less complex and can be incredibly powerful. However, before investing your money do your research before investing. Make sure you understand what an index fund is, how it works, what it tracks, and the advantages and disadvantages.

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