What is Index Investing?
Any investment comes with risk—especially investment in securities. If you’re the type of person who’s relatively risk-averse, it’s important to look for investments that mitigate risk through diversification. The simplest answer is index investing. Putting your money into an index is a great way to weather the ebbs and flows of the market, and ride its growth over time.
An investment index measures the performance and price movements of many investments to determine the overall performance of a specific investment type or sector. The S&P 500 and Dow are two of the most common indexes. Think of them like a gigantic basket of securities. While some stocks perform well, others fall, and everything balances down to an average. That average represents the price movement of an index fund.
Here’s what you need to know about index funds and index investing, and how to capitalize on the market’s growth through a balanced approach. First, let’s get to know the major indices.
Meet the Major U.S. Indices
There are many indices to choose from when looking for a broad-market investing approach. Generally, investors tend to choose from the ones most widely tracked and traded
- S&P 500 (SPX) tracks the performance of 500 large public companies.
- Dow Jones Industrial Average (DJI) tracks 30 prominent U.S. companies.
- Russell 2000 (RUT) a collection of 2,000 small- and mid-cap companies.
- Nasdaq Composite (IXIC) complete list of stocks listed on the NASDAQ exchange.
- The Wilshire 5000 (TMWX) measures the complete stock market’s performance.
As evidenced by the indices above, there are many different types of index funds to choose from. It’s possible for investors to choose their level of risk based on the depth and focus of an index. For example, an investor may seek a higher (yet relatively stable) risk-reward tolerance investing in the Russell 2000 (RUT) as opposed to the much broader S&P 500 (SPX) index.
A Note About ETFs
Index funds aren’t the only way to track the broader market. Many exchange-traded funds (ETFs) track the major indices (or part of them). ETFs open the door to more options in terms of how to leverage broad-market performance, but also come with additional management fees and performance that may deviate from the greater market.
Low Risk, Low Reward, Long Horizon
As an investment philosophy, index investing is widely considered safe and passive. The philosophy is simple: stock markets generally go up over time, so parking money in an index is a sure bet with a long-enough time horizon. The goal is stability and consistency. Index investors avoid big swings and surges and instead, see slow and incremental growth over time.
Index investing means settling for an average return on investment. Tracking an index means there’s no chance to outperform the stock market as a whole. That said, it means there’s no way to under-perform, either. You’re unlikely to see the skyrocketing returns of risk-friendly growth investors, but you’ll also avoid their staggering losses when market sentiment turns.
The key to all this stability and consistency is diversity. Whether it’s the 30 largest stocks or the 2,000 smallest, indices minimize risk by maximizing exposure. Over a long enough time horizon, it affords investors all the benefits of compound interest, without the risk of stock picking.
The Benefits of Index Investing
Index investing is all about stability, and is ideal for “set it and forget it” investors. There’s little-to-no volatility to worry about and rarely any major movement. This is the primary reason many investors flock to index funds. They’re also simple to engage with, and any investor can buy into an index fund or an index-tracking ETF.
Another great benefit is the low cost of investment—many index funds are low-to-no fee, since they’re passive. Investors retain more of their earnings over time, and pay only a small premium for the stability of broad market exposure.
Finally, while there’s no such thing as a sure thing in investing, index funds have an undeniable track record. They’ve even proven themselves to generate higher ROI than actively managed funds—a famous 10-year-long bet by Warren Buffett showed the power of passive investing.
The Drawbacks of Index Investing
The biggest drawback to index investing is that it requires a long time horizon. Index investors tend to hold for decades to capitalize on the compound annual returns of the market. In many ways, it makes these investments relatively illiquid (even though investors can exit their position at any time).
Index investing also settles for a much lower rate of return than other forms of investing. For example, broad investments in one or two sectors can outperform the index if other sectors lag behind. Investors can still get broad exposure and capitalize on strong returns from well-performing industries or companies.
Finally, not every index behaves the same. Price-weighted indexes differ from cap-weighted indexes, and their behaviors can diverge as a result. For example, if a mega-cap company drops significantly, it’ll pull down a cap weighted index much more than a price-weighted index. Investors need to be aware of the structure of an index before they invest.
Is Index Investing Right For You?
If you’re someone who hedges against risk and overthinks their investments, index investing could be a simple way to soothe your mind. The low-risk nature of broad-market funds and the passive, extenuated nature of index investing makes it a great way to accumulate wealth without worrying about the everyday ups and downs of the market. Index investors know that their wealth will grow over time—it’s just a matter of time. To discover the latest investment strategies to building wealth, sign up for the Liberty Through Wealth e-letter below. You will also gain access to expert index fund picks and much more.