Investing in stocks and bonds is one of the best ways to accumulate wealth over a lifetime. Some people like to study the market and individual stocks to make buying and selling decisions. But this takes work and not many people have the luxury of that much time to spend studying the stock market. Besides, over the long term, it's difficult to earn a return better than the overall market.
For those who prefer a simpler alternative, there are index funds. Here's how index funds work and the pros and cons of investing in them.
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What Is an Index Fund?
An index fund is a mutual fund or exchange-traded fund where the manager simply buys the stocks that make up the index since you cannot invest directly in an index. The goal is for the fund is to track the movement of the index as closely as possible.
Index fund managers do not aggressively manage the fund's holdings. Instead, the managers follow a passive buy-and-hold strategy rather than trading stocks in an attempt to achieve better returns.
Some examples are stock index funds based on the Standard & Poor's 500, the Dow Jones Industrial Average, the Russell 2000 and the NASDAQ 100.
Consider also: What Are Mutual Funds?
Pros of Index Funds
Here are the advantages of investing in index funds.
Low fees: Index funds typically have the lowest management fees of all mutual funds and ETFs. Since these funds are passively managed, you're not paying for stock analysts to research and trade stocks in an attempt to maximize return. Because of the lower fees, more of your capital is put to work to generate returns with increased compounding over the years.
Steady returns: Your gains and losses go with the market, and the market over the years has had a steady rate of return. Mutual funds managers who are aggressively buying and selling stocks are rarely able to consistently beat the returns of the overall market. You have more consistent returns and less risk with index funds.
Tax avoidance: Since index funds are passively managed, there is no active buying and selling of stocks that could create capital gains, which could be taxable.
Simplicity: With index funds, you invest in the total stock market. You don't have to spend time studying individual stocks to decide which ones to buy and when to sell. You simply invest in an index fund and go with the market.
Diversity: Index funds contain a large number of stocks, so your investment is diversified. It's not concentrated on just a few individual stocks.
Consider also: How to Read the Stock Market Index
Cons of Index Funds
Index funds are not without their disadvantages. These are some of the reasons an index fund may not fit your investing profile.
No flexibility: If the market is going down, index funds will go down with it. Since they're passively managed, you don't have fund managers adjusting the portfolio to limit losses, like shifting money from equities to bonds.
Lack of risk management: Although index funds have a number of holdings, they are nevertheless still concentrated. The S&P 500 has the 500 largest companies, and the Russell 2000 consists of 2,000 small companies. Even the well-known Dow Jones Industrial Average is made up of just 30 companies. Investing solely in any of these index funds means that you could be missing out on opportunities in other areas, such as real estate or international companies.
Not participate in innovative trends: The companies in index funds are mostly larger, older and rarely create new trends. Innovative and game-changing discoveries usually come from smaller companies that are not in any index funds.
Can miss out on large gains: Index funds tend to move steadily in one direction or the other and rarely experience huge swings, either up or down. More actively managed funds will occasionally have a winner that produces gains of 30 percent or more.