Index funds are one of the best ways to invest for both beginners learning how to invest and sophisticated investors looking to build wealth.
Why? Because they are one of the cheapest and easiest ways to get exposure to the market as a whole.
What is an Index?
An index is a basket of securities/companies that represent and measure the performance of a specific market. It’s used to measure and observe the overall health, past and present performance, and price changes of companies within a particular market.
Four examples of an Index:
- S&P 500 Index: The S&P 500 Index is a basket of 500 of the largest United States companies
- Russell 2000 Index: An index that tracks the performance of 2,000 small companies in the US
- MSCI Europe Index: This index measures the performance of a number of large and mid sized companies across 15 developed countries in Europe
- MSCI ACWI (All Country World Index) – A global equity index designed to represent performance of a set of large and mid-sized stocks across 23 developed and 24 emerging markets around the world.
A market index is not something you can directly invest in.
BUT you CAN have exposure to and invest almost identically to the market index by investing in an index fund.
How Can You Invest in an Index? By way of an Index Fund
An index fund is an investment that’s sole purpose is to track a market index.
You cannot go invest in the S&P 500 Index directly. BUT you CAN invest in the S&P 500 index funds created by different brokerage firms like Vanguard, Fidelity, Charles Schwab, etc.
Two ways to invest in an Index Fund:
An Index Fund – A type of mutual fund. An example of an index fund that tracks the S&P 500 Index is VFINX – the Vanguard 500 Index Fund.
An Index ETF – A type of ETF. An example of an index ETF that tracks the S&P 500 Index is VOO – The Vanguard S&P 500 Index ETF
(*Note* – The term index fund is used interchangeably with Index ETFs. The only major difference between the two are the way they trade on the exchange. For purposes of this blog post – Index ETFs or Index Mutual Funds will be called Index Funds) Read this blog post to learn more.
These brokerage firms created an opportunity for investors to easily get access to a broader scope of the market by being able to invest in 1 single index fund – where within that 1 fund it may hold hundreds or thousands of companies.
They effectively do the work for us, provide diversification and overall exposure to a market at a fraction of the time it would take for you to do yourself or the cost for you to pay someone else to do for you. Win win.
5 Reasons to Invest in Index Funds
- LOW FEES
The fees associated with most, if not all, index funds are inexpensive as a comparison to many other investments made available to you. Why? Because index funds are passively managed. They invest just like the index – much of the work is done for the portfolio manager.
They aren’t making their own company and investment selection decisions like an actively managed fund would. Therefore, the fees and barriers to entry are low. - LIQUID
By investing in index funds your cash is essentially liquid. Meaning that your money is not locked up for a long extended period of time where you won’t have access to it when you need it.
You can buy or sell quickly and can have access to the cash within days giving you the flexibility you may need. - LOW MAINTENANCE
Index funds are not a buy and sell, go in and out, try to make a quick buck type of investment. Think LONG term, buy and hold. Easy, low maintenance investing. - TAX EFFICIENT
There is less activity (less buying and selling of investments by the portfolio managers) within the passively managed index funds and thus reducing the capital gains income distributed to you.
Much of the income generated from equity index funds is distributed in the form of qualified dividends or capital gains as well, which are taxed at lower capital gains rates vs higher ordinary income tax rates. - DIVERSIFICATION LOWERS RISK
Index funds have lower risk compared to investing in an individual stock or a number of other investment options. Why? Because index funds invest in hundreds or thousands of stocks which provides a layer of protection by way of diversification. You are not protected from all market risk, but you are not at risk of the performance of one single stock or company.
Index funds may not be the answer for everyone but I believe they are an incredible option for the beginner, average and sophisticated investor alike for all the reasons mentioned above.
Make your money work smarter, not harder for you!
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