For most investors, a portfolio of index funds is more than enough to meet their long-term financial goals. Index funds are some of the most popular, readily available, and valuable investments on the stock market. They’re also very affordable and easy to access. Still, many people aren’t exactly clear on how they work or how to buy them.
I’ve been getting a LOT of questions on index funds lately, so I wanted to explain what they are and how they work, so you can see what an awesome investment these are for millennials!
What exactly are index funds?
To understand index funds, you only need to understand what the words “index” and “fund” mean.
A fund is a collection of related investments, usually stocks, that trade as a single unit. A fund manager selects the securities that are to make up the fund, bundles them together into a single package called a fund, and then sells shares of that fund to investors.
An index fund is a collection of investments that represent an index. An index is a measure of something. In the stock market, an index usually represents a particular industry, geographical region, or type of investment. For example, you can buy an index fund that mimics the oil and gas industry, or one that follows the US stock market, or one consisting entirely of bonds. Index funds contain investment securities in the same proportion that they are represented by size in the stock market, so the largest company on the US stock market would also be the largest holding inside a US stock index fund.
Index funds are typically mutual funds and exchange traded funds (ETFs). Both of these are managed by a fund manager that you pay a small fee to for his trouble of selecting the investments and managing the fund. Mutual funds charge higher fees than ETFs, but are easier to access because they’re typically sold by your bank, have very low entrance requirements (you can get started with as little as $25!), and don’t require any ongoing management effort on your part. ETFs are much cheaper than mutual funds in terms of fees, but you need a brokerage account to buy them, which usually requires at least a $1,000 deposit. You’ll also have to take a bigger role in managing your ETFs portfolio than you would a mutual fund.
Why are index funds a good investment?
Index funds are a cheap way to diversify your portfolio, which can reduce your investment risk and increase your exposure to the whole market. Not only does this protect your portfolio from major market swings, it can also increase your investment income.
Think about it this way: if you have $1,000 to invest, you can buy 1 share of Google or you can buy a small piece of 500 different US companies, including Google, by buying shares in an ETF representing the S&P 500 index. Which would you choose?
Google isn’t a bad investment, but you are putting all your eggs in one basket. If the stock goes down, your whole portfolio goes down. If you want to buy a few shares of something else, you’d have to sell your entire holding in Google, pay the trading commissions, and then reinvest in something new. If you own an ETF of the S&P 500, if Google goes down in price, your investment might dip a little, or you might not even notice it at all. In fact, if the other holdings in the ETF are doing well, you could still see your investment increase in value, even if Google and few others are having a bad day.
Google doesn’t pay a dividend, but many stocks do. When you own an index fund, you will receive dividend payouts from these companies in the form of a dividend from the ETF. Many ETFs pay out quarterly, but a few pay out monthly. If you’re looking to increase your passive income, slow and steady investing in index funds is an excellent way to do it.
Index fund investing is EASY
The beauty of investing in index funds is you probably only need to own 2 or 3 to have a fully diversified investment portfolio. It really is that easy. All you need is a broad stock market fund and a bond fund and you’re done.
However, if you want to take a more active role in managing your portfolio, you can diversify further with more specific index funds. You might choose to add an index fund representing emerging markets to your portfolio, or one containing only socially responsible, green, or ethical investments. Truthfully, there are index funds as broad or as specific as you want, which means you still have a lot of flexibility over the asset allocation in your portfolio even though you are not holding individual stocks.
If you want to buy individual stocks, you still can. I personally love building the foundation of my investment portfolio around core ETFs, and then investing in individual companies I find interesting or exciting to further diversify my portfolio. This protects my overall wealth from dramatic market fluctuations, while still letting me enjoy a more hands-on active trading experience.
Do you invest in index funds? What’s your experience so far?