7 Things to Remember About Index-Oriented Investing
Investing follows two major approaches – active investing and passive investing. With active investing, investors take on an aggressive front. They buy and sell stocks to earn a profit in the short term. The risk quotient is high here, but so are the returns. Passive investors, on the other hand, have a different way of earning rewards. They invest in passive funds, such as mutual funds, exchange-traded funds, and index funds. The rewards they earn entail lower risk and are delivered over time.
This article talks about index funds and some important aspects that can help you decide if these funds are suitable for your portfolio.
What are index funds?
Index funds are a type of mutual funds that form a part of passive investing. Index funds aim to bring returns similar to a benchmark index (such as S&P 500 or Nasdaq) consisting of various stocks and bonds. An index fund tracks the market index with a goal of matching the index’s return.
Index funds are slowly gaining popularity in investing as this passive fund has the ability to give better returns than active investing in the long run.
Here are some examples of index funds in the U.S:
- Vanguard 500 Index Fund
- Fidelity Sustainability Bond Index Fund
- Direxion Work From Home ETF
- iShares Russell 2000 ETF
What are the things to keep in mind about index funds or index-oriented investing?
Here are 7 things to remember about index-oriented investing:
1. Index funds offer a safe and low-cost investment tool
Since the fund mimics the performance of the benchmark it follows, the returns are stable and predictable. The element of surprise is relatively low as compared to active funds or stocks. The only financial set back in index fund investing comes in the form of fund management costs. These costs are also relatively low. Moreover, there are no trading costs, taxes, or any other hidden expense. Hence, the overall returns remain steady. The fund simply mirrors the market index and delivers you rewards. This also reduces the chances of emotional buying and selling of stocks. Active investors are often engulfed with emotions of fear, panic, anxiety and sometimes even greed. However, with index fund investing, there is not much to get yourself involved with in the first place. You put in your money in the fund, and the fund follows the market index. As a result, your returns are balanced and reliable.
2. Index funds offer the benefits of diversification
Diversification is a tried and tested technique to minimize losses in investing. As per the principles of diversification, your money should be spread across different asset groups and investment types rather than be concentrated on one product or industry. While this sounds simple, the execution can be a little tricky. For one, it can be hard to buy stocks of multiple companies. The management, monitoring, as well as the periodic buying and selling, is a time-consuming process. Owning stocks in several companies is also not a cost-effective approach for everyone. But index funds allow sufficient exposure with easy diversification. This lowers your overall risk and offers you better market opportunities.
3. Index funds do not offer much flexibility
Since an index fund copies the performance of the market index, there is little to no scope for any flexibility for the fund manager. If the market index does well, the fund also does well. If the market index performs poorly, the fund also performs poorly. There is very little control in the hands of the fund manager to evade such a loss or maximize the gains further. Therefore, the flexibility quotient in these funds remains rather low.
4. Index funds rarely ever beat the market index
While following a market index ensures consistent returns, the possibility to outdo the market index is negligible. It is extremely hard to outperform the market index. Moreover, while you earn the profits of the index if the market is booming, you are also subjected to the losses of a falling market. Your money gets stuck with the index and performs in the same manner as the benchmark.
5. Index funds are suitable for risk-averse investors
Index funds are simple to understand and. hence, fit all requirements of a new investor. If you are inexperienced when it comes to investing, index funds can offer you access to a wide variety of options. Moreover, since they merely follow a benchmark, there is no need to time the market or look for opportunities to make money. While the returns from an index fund are stable and steady but never too high, the losses are also negligible.
6. Index funds are beneficial over the long run
Index funds are a good instrument for long term goals as they tend to deliver results over the course of a period. If you are looking for short term gains, these funds may not be ideal for you. They provide better opportunities if you can buy and hold your investment for some years.
7. Index funds offer transparency
When investing in index funds, you can see the fund’s holdings anytime you want. This offers an excellent level of transparency in how and where your money is being invested and how it is performing. This is also beneficial to an inexperienced investor who may not have enough knowledge of the market. With a high degree of transparency, you stay informed at all times.
To sum it up
Index oriented investing is a great option for investors with a medium risk appetite. It exposes you to diverse options and at the same time, offers steady returns that help you earn profits over time. Some studies show that index funds have also outperformed active funds in the long run. However, keep the points mentioned above in mind before making a decision to invest in an index fund.
If you are looking to invest in index funds, you can contact a financial advisor in your area to understand how these funds work and if they make for a good choice for your profile.