8 Problems That Could Be Solved by Index Investing
When it comes to investing, there are many different approaches. However, no matter the approach you follow, the one thing that is always recommended is to ensure proper diversification. Diversification, in the right measure, can control and reduce risk and volatility. When you put your money in different types of investment instruments, you have a higher chance of earning better profits. This is because no two industries or assets react to the market in the same way.
As you diversify your investment portfolio, you can keep in mind to add a mix of different industries. For instance, instead of only investing in technology, you can keep a mix of pharmaceuticals, food, motors, and technology. A professional financial advisor can help you to help diversify your investments to minimize risk and volatility in your portfolio over time. Apart from the industries, you must also keep in mind to add different investment instruments, such as stocks, bonds (municipal, corporate, government), real estate, insurance, and mutual funds. You can also further diversify within mutual funds by selecting index funds. Index funds are known to offer many benefits and can be a worthy addition to your investments. Read on to know more.
What is index investing
Index investing refers to investing in index funds. Index funds are a type of mutual fund or exchange traded fund (ETF) that track the performance of the benchmark index they follow, such as the S&P 500, Vanguard 500 Index Fund, Fidelity ZERO Large Cap Index, SPDR S&P 500 ETF Trust, Schwab S&P 500 Index Fund, iShares Core S&P 500 ETF, iShares Russell 2000 ETF, etc.
Index investing is a form of passive investing, and the index fund mimics the performance of the index it follows. Index funds can offer many advantages to investors and help to solve some very apparent investment problems, such as the ones listed below.
8 problems that can be solved by index investing:
1. High risk on the investment portfolio: The myth that high risk results in high returns has been plaguing the financial world since time immemorial. The truth, however, is not so simple and straightforward. While high risk stocks have been shown to offer higher returns, the connection between risk and reward cannot be easily established. There are many low risk investment options that can garner returns as significant as high risk ones. Index funds are a brilliant example of one such option. Index funds follow a benchmark index and deliver the same performance as the benchmark. This eliminates all risks. The returns are generally unwavering and predictable. This is particularly suitable for investors who prefer passive investing over active investing. There is no need to time the market or make crucial decisions. The index does that for you. This ensures that your returns are always steady and the risk involved is always low.
2. Poor or low diversification of investments: Poor diversification is a grave problem that can reduce the returns on your investments and lead to unwanted volatility. Some investors end up over diversifying or not diversifying enough that negates the positive impact of diversification and brings risk to your investments. Thankfully, index funds can help with optimal diversification. An index fund can offer multiple holdings at one time, sometimes going up to thousands in total. As compared to an actively managed fund that can invest in as low as 50 holdings, index funds can bring a lot more exposure to your investment portfolio. An index fund can hold different stocks ensuring a well-diversified portfolio. Since no two stocks would react to the market in a similar manner, you are able to earn great returns and gain exposure to different industries and companies. This way, the index fund performs well and matches the benchmark’s performance, delivering high returns.
3. High investment fees and costs: High investment costs can take away from the profits earned by investing your money. Hence, it is important to include more instruments that come with low costs to balance out your returns. Index funds are low cost investment options as they are passively managed. The fund management costs of index funds are relatively low as the fund simply mimics the performance of the benchmark. There are no managers who have to research, track the market, or make timely decisions. Moreover, index funds have no trading costs and very little tax liabilities.
While the index funds are inherently low cost funds, it may be advised to look for an index fund with a low expense ratio to ensure more cost-effectiveness.
4. Human bias and prejudice in investing: Human bias, past conditioning, fear, greed, prejudice, and other emotional factors can sometimes turn the tables in investing. In the case of actively traded funds, investors or fund managers are driven by their past experiences, doubts, and anxiety. They are constantly involved, timing the market, and are likely to make buying and selling decisions at the spur of the moment that may or may not benefit them in the long run. However, this is eliminated in the case of index funds. As stated above, an index fund is passively managed and the only purpose of the fund is to match the benchmark’s performance and not beat it. This removes all human prejudice and scope of error. The index performs as per the market and there is no human interference in between.
5. Low returns: Investing can multiply your money and secure your future. The primary purpose of investing is to earn more money. Hence, low returns can certainly be a setback and sore point in investing. Low risk investment options can sometimes lead to lower returns. However, index funds are an exception here. The returns from index investing may not be as high as equity stocks, but they have always been steady and there are many past figures to prove this. In 2011, the U.S. News and World Report had announced that as per their observations, index funds following the S & P 500 Index had garnered higher returns than two-thirds of large-cap actively managed mutual funds in the previous three years. Earlier in the year 2007, investor and business tycoon, Warren Buffett had made headlines for winning a $1 million bet that an S & P 500 Index Fund had the potential to overpower the returns of an actively managed hedge fund over a period of 10 years. In 2013, investment analyst, Rick Ferri and certified financial planner, Alex Benke revealed a study that showed that index funds outperformed similar active strategies 80 to 90% of the time. All these statistics establish the high returns associated with index funds with very little risk involved. In a way, you can kill two birds with the same stone with index funds – low risk and high returns.
6. High tax liabilities: The tax levied on your investment returns can substantially reduce their value. This is particularly problematic in the case of mutual funds or stocks held for less than a year. When you hold an asset for less than a year and sell it to make a profit, you are subjected to short term capital gains taxes. However, if you hold the asset for more than a year, you pay long term capital gains taxes on them. Long term capital gains taxes are much lower in comparison and ensure that you keep a large part of the earnings for yourself, rather than losing it out to taxes. The turnover ratio plays a crucial role here. The lower the turnover ratio, the lower is the tax output and vice versa. Index funds have a low turnover ratio than other types of mutual funds, resulting in a lower tax liability too. This helps you earn more.
7. Lack of transparency: Keeping track of your investments is essential as it helps you understand how your money is being invested and how it is likely to perform in the future. However, not all investments are as transparent. Index funds, on the other hand, offer a great level of transparency to investors. The holdings of an index fund are publically available and can be checked by investors at any given time. So, whether you are a new investor or a well-experienced one, you know exactly how your money is invested and can always depend on index funds to be entirely transparent and straightforward. This way, you are in charge of your money all the time and up to date on how it is performing.
8. Tough investing strategies: While investing is a much needed activity in today’s time to beat inflation and secure your future financially, it may not be everyone’s cup of tea. There is a considerable lack of understanding and experience when it comes to investing. Many salaried individuals still refrain from it as a result of preconceived notions and the lack of time to manage their money efficiently. However, index investing simplifies all of this. Index investing ensures that you earn high returns from your invested capital, without having to go through the perils of manually timing the market, following the market trends, and making decisions to buy and sell. It is a hassle free approach to investing that can suit the youngest and most inexperienced of investors with a dependable guarantee of stable returns.
To sum it up
Index investing is a great addition to your investment portfolio for various reasons. It simplifies the investment process, lowers costs, reduces risk, eliminates high taxes, brings in diversification, and ensures that your investment is free from any bias or judgment. It can bring financial stability and peace of mind, ensuring safety for your invested capital. It is also transparent, so you can monitor your investments at all times.
If you are thinking of investing in an index fund, you can get in touch with a professional financial advisor in your area for expert advice on how to pick the best index fund that meets your requirements.