Index funds are one of the best ways to invest for both beginners learning how to invest and sophisticated investors aiming to grow wealth.
Why? Because they are one of the cheapest and easiest ways to gain exposure to the market as a whole.
What is an Index?
An index is a basket of securities/companies that represent 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.
Examples of Popular Indices:
- S&P 500 Index: The S&P 500 Index is a basket of 500 of the largest U.S. companies
- Russell 2000 Index: An index that tracks the performance of 2,000 small companies in the U.S.
- MSCI Europe Index: This index measures the performance of a number of large and mid sized companies across 15 developed European countries
- 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 invest in an index fund that mirrors its performance.
How to Invest in an Index Fund
An index fund is designed to track a market index. There are two main ways to invest:
- Index Mutual Fund – Example: Vanguard 500 Index Fund (VFINX), which tracks the S&P 500 Index
- Index ETF – Example: Vanguard S&P 500 ETF (VOO), also tracks the S&P 500 Index
For simplicity, both will be referred to as “index funds” in this post.
By investing in an index fund, you get broad market exposure in a single investment. These funds are diversified, low-cost, and managed passively, making investing easier and more efficient for you as the investor.
They effectively do the work for us, providing 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
1. 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.
2. Liquidity
By investing in index funds your cash is essentially liquid and accessible. 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.
3. 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 and watch your money grow. Easy, low maintenance investing.
4. 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.
4. Diversification Lowers Risk
Index funds invest in hundreds or thousands of stocks, spreading risk across multiple companies. While you’re still exposed to market risk, you’re not dependent on the performance of a single 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.
They’re simple, cost effective, and designed to let your money work smarter, not harder.
Additional Resources:
Follow @finpoweredfemale for more personal finance, investing, tax and business ownership tips on building wealth with confidence!
Join the FinPowered community and subscribe to weekly emails for more personalized finance tips!
RELATED POSTS:
