When you decide to invest in the stock market, you will likely start paying more attention to financial news and updates. At this point, you will start hearing about index funds. What exactly are index funds, and how do they relate to a market index?
What are Index Funds
An index fund is a mutual fund or exchange-traded fund that is made up of holdings designed to match that of a market index. An example of a market index could be the S&P 500, or the Dow Jones. The S&P 500 is an index that is comprised of 500 of the largest public companies in the United States, while the Dow Jones tracks 30 of the largest firms in the United States. By looking at both of these indexes together, it is a good method of determining how well the stock market is performing as a whole.
How do Index Funds Work?
Money that is put into an index fund will be used to invest in stocks that the market index is comprised of. Therefore, when the market index changes in value, your index fund will correspondingly change as well.
Index funds are not actively managed, they are a hands-off investment. Instead of using a financial advisor or account manager, you would have a computer tracking the market and rebalancing your index fund to match.
By investing in an index fund, you are basically guaranteeing that you will perform just as well as the market does in a particular year. Index funds tend to pay off in the long run; if the market has a bad year, it will often stabilize itself in the following year. Index funds are a good way to get into the market when you do not have an extensive financial background. Simply pay attention to the major indexes, and you will understand how your portfolio is doing.
Advantages of Index Funds
Investing in an index fund tends to be a lower risk than putting your money towards individual stocks. Stocks are more volatile than entire indexes, so it is unlikely that you will lose all your money after one bad day in the market.
Index funds are cheaper to invest in because there are fewer fees associated with them. They are less work than managed investment accounts, as they are simply mimicking the market index. Therefore, there are fewer commission and account fees to pay.
Another pro is that index funds diversify your portfolio. The risk is being spread around, across a greater number of investments. It also allows you to have a wider mix of different industries and assets.
Disadvantages of Index Funds
The major disadvantage of investing in index funds is that there is a lower reward since there is a low risk of investing in them. It is difficult to earn a large profit, as there is when investing in individual stocks. This is considered the opportunity cost of investing in index funds, as your money could be going towards something that will give you a higher profit.