How to Invest in Index Funds
Looking for a low-fee, low-hassle, low-risk way to invest? Any seasoned investor will recommend you invest in index funds. Why? Because these investment vehicles are about as low-risk as they come. Index funds tap into the growth and appreciation of the stock market, but are so broad and diverse, they tend to move the needle very little on any given day. If you want to avoid the heart palpitations of a hand-picked portfolio, an index fund will give you the broad exposure you’re looking for with none of the uncertainty.
A form of passive investing, index funds fall into the “set it and forget it” realm. That said, you should still understand what they are and how they work. A baseline understanding of these funds will help set the expectation for your investments. Here’s a primer on index fund investing and why it’s worth it for long-term, low-risk appreciation.
What is an Index Fund And How Do They Work?
An index fund is a broad array of securities, packaged together for investors. Technically, it’s a type of mutual fund. These funds track a particular market index, which makes them a passive investment option. Investors with low risk tolerance will have no trouble contributing funds and watching them pace the market.
What Kinds of Index Funds Are There?
Typically, index funds have a theme. They’re a portfolio of stocks selected for a specific reason. Here’s a look at some of the most common index funds and how they’re assembled:
- Broad market funds: This is the most diversified type of index fund. It tracks high performers from across all sectors of the market.
- International funds: These funds look abroad for companies that can outperform the broader market. Emerging market funds also fit into this category.
- Market cap funds: These indices focus on collections of small, medium or large cap companies. They’re weighted by company market caps.
- Earnings-based funds: These funds track high-performers. They make money on the growth of companies that consistently outperform the broader market.
- Dividend funds: These funds track high-yield dividend payers. They’re designed to return a majority of value to shareholders through dividend payout and reinvestment.
- Sector-specific funds: From energy to industrials, technology to real estate, these funds use certain criteria to track performers in a specific sector.
- Bond funds: These indices track the performance of bonds, including municipal and term-based bonds. They’re often less volatile that stock-focused indices.
- Socially responsible funds: These funds consider social responsibilities such as environmental friendliness and social justice, to track moral companies.
- Leveraged funds: These funds track a broader index and use options to return multiples on the performance of the underlying fund.
These aren’t the only types of index funds. Moreover, there’s a broader opportunity out there for index diversity based on the major indices they track. You might choose to invest in a dividend fund that tracks the S&P 500. Or, you might want a cap-weighted sector-specific fund that tracks the broader sector index. There are index funds to suit a broad range of investing styles and risk tolerance.
Index Fund Factors to Consider
As you consider index funds, you’ll need to pay careful attention to a few governing factors. Compare these options against your investing style and thesis to make sure you’re selecting the best one:
- Asset type: Choose between debt and equity securities, commodities, cash, etc.
- Market cap: Many indices specifically include or exclude companies by cap size.
- Sector: Indices typically take sector exposure into consideration.
- Opportunity: Do you like growth stocks? Dividend payers? Emerging markets?
- Cost: What is the expense ratio of the fund? Is there a minimum? Check fees first.
- Performance: How well has this fund performed against the index it tracks?
All these factors play a role in narrowing down the best index fund for you to invest in. Sometimes you’ll end up with a niche index, like the Amplify Online Retail (IBUY) ecommerce-focused index. Other times, you’ll realize that a major index is best for you, like the Russell 2000 Index (RUT).
The Pros of Index Investing
The major positive of index investments is that they’re hands-off. You can keep contributing to them and profiting as the market continues to go up. There’s not a lot of thinking required! So long as you choose a low-fee index fund and that fund continues to perform, your investment will grow. The longer your time horizon, the better you’ll do. Index funds are also liquid—easy to enter and exit positions. That means you can keep building on a strong position or access your funds whenever you need them.
Understand the Cons of Index Funds
There’s not much of a downside to index investing, other than the prospect of missing out on more lucrative investments. You need a longer time horizon for most index funds to yield major returns—which means having the patience to ride it out. The other minor downside is that you’ll also pay for better fund performance. High-performing indices with active management typically demand higher fees, which can eat into profits.
Keep a Passive Eye on Index Fund Investments
There’s not a lot to do when you choose to invest in index funds. Making regular contributions and letting the market do its job is really all there is to it! The only real danger you face is the prospect of a bear market or a severe correction that takes many years to recover from. Even then, with a long enough time horizon, your index investment will outpace inflation with ease.
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It’s a smart idea to keep an eye on your index investment over time. You might decide to move out of a small cap fund as you get closer to retirement or allocate more specifically into a low-cost fund that offers better performance. These are small but important considerations. Taking the time to pay attention to them will net you years of worry-free investment from an index fund.