Index funds offer you a simple, easy and inexpensive way to invest in stocks and bonds without having to choose them yourself. Better yet, it is actually that recommended Wealth Building Strategy for the Average Joe. You can use index funds as your main investment strategy to guide you through retirement and beyond.
If the whole flashy GameStop business felt complicated, here’s a consultant-approved way to build wealth through index funds.
If growing your wealth with less stress and steady returns sounds like your investment style, index funds might be for you.
What is an index?
An “index” is a statistical tool used to measure the value of an industry. For example, the S&P 500 is one of the most well-known indexes and measures how well the top 500 companies in America are doing. In this case, it’s an index of the overall economy, and it’s what you see on the news every night when the news anchors talk about the market going up or down.
What is an index fund?
Index funds are relatively new inventions. They were first popularized in 1976 by the undervalued hero of nerd investing culture, Jack Bogle.
Before Bogle, there was only one way to invest in stocks without buying them outright: by paying someone to choose them for you in the form of a mutual fund. You could buy a share of a fund knowing that someone smarter than you will select the stocks to invest in that fund.
The idea was that by managing the fund you would get an above average return – except in most cases, you wouldn’t. Mutual funds still exist today, and that is still true today: Even experienced stock pickers generally earn less than the overall market, as measured by indices such as the S&P 500.
This led to a lightbulb moment for Bogle: if the index outperforms actively managed funds anyway, why not just create one based on the index? On index Funds, if you want.
How index funds differ from ETFs and mutual funds
If you are new to the investment world, there are three terms you will use frequently: index funds, mutual funds, and ETFs. It is important to know how different they are so that you can choose the right one for you.
Investment funds are a collection of stocks that you can buy a stock of. They can either be actively managed by a living human or by an index fund. You read that right: on Index funds is just a type of mutual fund where stocks and bonds are selected based on preset criteria rather than a live person.
ETFs Learn more about how buying and selling investments actually work. ETFs are traded on the daily market instead of at the end of the day as with mutual funds. You can generally buy ETF versions of both index funds and actively managed funds. They also have lower minimum investments. So if you only have a few dollars to spare, this might be a better choice for you.
Types of index funds
Index funds were originally linked to an index. For example, an S&P 500 index fund contains all of the companies listed in the S&P 500 index. If a company leaves the index, the index fund also changes.
Over time, however, the index funds were further expanded to include non-index funds. Still, every index fund starts with preset rules about what types of stocks and bonds cause the cut in the fund. The decisions about which investments to select are not made arbitrarily, as is the case with actively managed funds. Here are the main types of index funds:
- Equity funds. These are index funds that only hold stocks. This is an umbrella term that can also describe other index funds such as ESG funds.
- Pension funds. Most advisors recommend holding some bonds, and you can do that with an annuity fund.
- Sector and special funds. These funds invest in specific industries such as technology, hospitality and agriculture. This gives you a little more control over what to invest in, for example, if you think a particular industry is on the rise.
- Target funds. Consultants recommend that you change how much you have invested in stocks or bonds as you near retirement. Funds with a reference date do this for you automatically. So all you have to do is choose your retirement year.
- ESG funds. These funds invest in companies with a strong ESG (environmental, social and corporate governance) component. These are companies that benefit society, or at least do not actively harm it. For example, if you don’t want to invest in firearms or the fossil fuel industry, those funds might be your ticket.
Advantages and disadvantages of index funds
Index funds aren’t perfect, and you give up some things if you choose to invest in them. You need to understand the pros and cons of index funds to decide if they are right for you.
There are a handful of benefits index funds offer investors. Here are the advantages of index funds.
Most investments only charge a small fraction of your portfolio amount as payment. It doesn’t seem like much until you do the math and see that in some cases, these fees can gobble up around 40% of your total returns over time.
In contrast, index funds are the cheapest investment there is because they are operated with an autopilot. If you choose them, you could end up with tens of thousands (or hundreds of thousands) of dollars more over time.
Minor tax bills
When you invest in index funds, not only does it cost less, but you also have to pay less tax. That’s because actively managed funds often buy and sell stocks, and every time they do, you can owe taxes. Index funds don’t do this so much, which lowers your tax exposure.
Simple, passive way to build wealth
You don’t need to know the pros and cons of investing. Even your grandma could probably figure this out if she spent enough time on it. And once you do When you get this basic investment concept, you basically don’t have to do it anymore: just put money in the fund until you retire (or otherwise need it) and then take it out. Easy. No stress.
Great way to diversify your portfolio
It is important to diversify so that you don’t put all your eggs in one basket. For example, the last thing you want to do is toss every last penny you have into Tesla stock. Index funds provide an easy way to achieve this diversification without doing the job of personally reviewing each company.
Index funds tend to ride the waves of the market up and down like a pool toy. You mean can Lose money when the market falls. But you’re not doing anything super risky like stock options or short selling.
Index funds offer advantages, but also disadvantages.
Not that sexy
Getting rich by investing in Bitcoin or GameStop stocks is hot right now – Paris Hilton is hot indeed. However, investing in index funds is the turtle’s slow approach. It’s about as sexy as your grandpa – and we’re talking about it now, not when he was young. No one is going to praise your investing genius (even if they should) while you sit back and quietly make a bunch of money over time.
Not that much potential for high returns
If you really know what you’re doing, have a lot of discipline, and have plenty of time to research, you can get better returns with more active investment strategies. But that’s great if.
It’s not that easy to customize your portfolio
There are many different types of index funds to choose from. You can get pension funds. You can get ESG funding. You can even get Millennial-themed Funds and Live Livestock and Pig Funds if you want. However, you cannot customize what is in them.
To do this, you have to choose the stocks yourself. This bothers some people when they buy an ESG index fund, for example, and find that it is still investing in some companies that they disagree with. However, you can always check the fund’s prospectus to see what is in the mix.
How do I invest in index funds?
If you are still convinced that investing in index funds is the way to go? Here’s how to get started in four easy steps:
1. Choose an investment brokerage
You can buy shares in an index fund through an investment broker and even through some investment apps. So the first step is actually receive an account with an investment brokerage. This is usually about as difficult as opening a bank account (which you need to link after opening your brokerage account).
Some brokers also offer their own index funds. If you think you want to stick with these funds instead of having more choice later on, it might also be a good idea to open an account here instead. The upside is that it’s usually cheaper.
2. Choose an index fund
Next, select the desired index fund. This is the most common place where a lot of people get stuck.
If you’re really not sure which index funds to choose, a good start is a target fund based on the date you want to retire (like the Target Retirement 2050 fund).
You can even use this for short term goals. For example, if you want to buy a home in 10 years, you can choose a Target Retirement 2030 fund so that it will be allocated appropriately as you get closer to your short-term goal. You don’t necessarily have to use them just for retirement, although that is their most popular purpose.
Another option is to hire a paid financial advisor for a one-time financial plan. You can recommend certain funds to invest in so that you can create your own retirement savings from there.
3. Place your order
The details of how you actually buy the index fund, e.g. B. which buttons you have to click depend on which investment broker you have selected.
This is where choosing a brokerage company with good customer service can come in handy. If you have an intuitive digital user interface or can call the support line for a tour, you can have a streamlined user experience.
4. Rebalance your portfolio
If you’ve bought more than one index fund, you need to decide what percentage of your money to keep in each fund. For example, if you have two funds, you can opt for a 50/50 allotment, a 70/30 allotment, and so on.
Over time, they will deviate from these goals that you have set and you will need to correct them. You can do this by buying and selling shares in these funds to make up for it, or by simply adding more money to the account behind it. Most experts recommend sitting down at least once a year.
Is Investing in Index Funds Right for You?
Investing in index funds is a complete investment philosophy that is all about generating statistically verified returns slowly and measuredly. Instead of following the stock market tickers and noise, focus on the average trendline that is rising over time.
So, if growing your wealth with less stress and constant returns sounds like your investment style, index funds might be for you.