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How to Invest in Index Funds

How to Invest in Index Funds

 

 

Finding a reputable review about how to Invest in Index Funds, local or worldwide can be a difficult process, especially finding a complete list from a trustworthy reputable source.

 

 

A Quick Overview of how to invest in Index Funds:

 

Below is an in-depth review regarding how to invest in Index Funds to help you make an informed decision before trading

 

 

Overview

When learning about investment, ‘index fund’ is a term that may come up frequently. Index funds can be a great investment option, but they are a type suited for certain investors and they cater especially to beginners.

 

An index fund can be either a mutual fund or an exchange-traded fund (ETF) which is a basket consisting of a group of stocks, bonds, or a variety of other assets. One of the most crucial characteristics of an index fund is that it ties directly to a market index.

 

An index fund is a common investment vessel due to its simplicity and the benefits that they contribute towards portfolio diversification. Due to their simplicity, the fees involved are much lower than those with traditional investment strategies. These lower fees are the responsibility of index fund investors.

 

 

What is a Market Index?

A market index is a weighted index which consists of assets that have similar characteristics, such as either the same sector, class, geography, or market capitalization. There are hundreds of market indexes. Examples of market indexes include the following:

  • S&P 500 – which is a market-cap-weighted index. It weighs each holding based on the market capitalization of every underlying holding. The S&P 500 is considered as a large-cap index that holds the top 500 largest companies in the United States.
  • The Down Jones Industrial Average – which is a price-weighted index. In this index, every underlying holding is weighted based on the underlying price of every stock or bond. The Dow Jones is considered a large-cap index that holds the 30 largest companies according to their corresponding industry.
  • The MSCI South Africa Index – this is a measure of the performance of the large as well as mid-cap segments in the South African Market.
  • South Africa’s FTSE/JSE Africa All Share Index – this is a market capitalization-weighted index with companies on the index making up the top 99% of the market cap of all companies listed on the Johannesburg Stock Exchange.

 

Investors often benchmark their portfolios against these market indexes and subsequently compare results. Through this, investors have a set method to determine the performance of their portfolio, by comparing their portfolio’s return to the market index.

Should a portfolio outperform the most similar index next to that of the investor, it may be indicating that the investment strategy is superior to merely investing in the index.

 

Where did Index Funds come from?

Jack Bogle, one of the most famous investors of our time has had a hand in the creation as well as the widespread acceptance of investing in index funds. Bogle is the founder of The Vanguard Group and he has been an active advocate of index funds since 1970.

 

Besides, Bogle was one of the first fund managers involved with the development of mutual funds which tracked broad market indexes directly. The Vanguard Group is one of the largest asset managers globally and has a total of 5.1% trillion dollars of assets that are under management.

 

The Vanguard Group was founded based on Bogle’s principles, that investors can earn market returns over a span of time by investing in broad market index funds at lower costs.

 

How do Index Funds work?

As previously stated, index funds can either be mutual funds or ETFs which track a market index. When investors purchase an ETF or a mutual fund, they are virtually purchasing a basket that consists of underlying stocks or bonds.

 

Investors have the option of buying and selling funds actively every day, or they can hold them over the long term. Many of these funds subject the investor to small fees which must be paid as a percentage of the investment which goes towards the management of the fund via a fund manager.

 

Index funds inherently have lower fees when compared to funds that are actively managed due to their simplicity.

 

How do dividends work when investing in index funds?

When purchasing an equity index fund, the investor becomes the owner of a small piece of every underlying stock in their basket and some of these stocks pay out dividends to investors.

 

When tracking larger indexes, such as the S&P 500, which holds 500 of the largest companies in the United States, there are 80% of these listed companies pay dividends.

 

In time, each of these companies is set to pay dividends to the index fund. Then, the index fund itself will provide a quarterly dividend payment to the holder of the fund. Through this, investors can earn compound interest.

 

Are Index Funds a good option for beginners?

Index funds offer the perfect opportunity for investors to gain broad market exposure to a diversified group of either stocks or bonds. They are also a perfect way for investors to diversify their portfolios, which means that there are fewer risks involved.

When investors ensure that they have a diverse portfolio and they have a group of stocks instead of holding individual stocks of a company, the overall risk of their portfolio decreases substantially. The term ‘do not put all your eggs in one basket comes to mind in this and the meaning carries through where stock investment is concerned.

Investors who put most of their capital in either one company, stock, sector, or industry, are exposed to substantial risks of losing all their funds should the company, stock, sector, or industry experience a sudden drop or financial challenges.

 

How can investing in an index fund help you diversify?

By increasing the number of holdings in the portfolio, the investor can diversify away from company-specific risks. As the investor adds more companies to their portfolio, the less susceptible they will be to individual risk from a single stock.

This results in the investor reaching a point in their portfolio where the only risk they are exposed to, is that of a broad market. Market risk, simply defined, is the holistic risk of investing in the financial market and it includes volatility, political events, interest rates, and recessions.

Of all the risks that can be managed, broad market risk cannot be eliminated or diversified away.

 

What is the Risk-Reward involved with Index Funds?

All portfolios come with a risk-reward profile which can be measured using various metrics as well as ratios. The risk-reward involved with holding a single stock in the portfolio is much higher than when investing in a basket of stocks as the investor places all their funds in that one single stock.

The risk may be high but the potential reward from holding a single stock is also higher. The position could go up substantially and at the same time, it could also plunge the investor into a negative return.

The risk is also high due to the potential volatility of the portfolio being increased.

Should the investor buy another stock, they will subsequently be holding two stocks. By adding another, the investor reduces the volatility of the portfolio as the movement in price between the two stocks can cancel one another out.

This reduced volatility is the basics concerned with diversification.

When investing in an index fund, volatility is eliminated by single stocks as the investor is investing in the market, which allows the investor to earn market returns while they are eliminating a single company risk.

 

The difference between Active and Passive Investments

When deciding what to invest in, investors need to decide how they want to manage their portfolios. There are two traditional ways through which investors can invest, either actively or passively.

These two types present a level of controversy in the investment community where some believe one is better than the other.

There are, however, investors who make use of both types to manage their profiles. It is, therefore, imperative for new investors to first explore what each type of management involves before deciding which would be more suited.

 

Active Portfolio Management

This type of management is more dynamic and there is a variety of active management styles, however active portfolios tend to be more flexible towards changes.

Active managers focus on beating the market over time and they often choose a benchmark index and try to capture higher returns than the index would over time. Also, an active portfolio manager will seek out market irregularities and take advantage of any events which may impact the prices of stocks.

Some of the events that could have a substantial impact on the markets include political events, earnings releases, economic events, breaking news, and numerous others. These are the types of events that an active manager who is trading equities could try to exploit.

 

Passive Portfolio Management

This is a strategy that is more strategic than active portfolio management. The goal that passive portfolio management has is to earn market returns over a span of time.

A passive portfolio manager aims to earn a return that is equal to that of a specific index.

Also, passive portfolio management does not require a proactive approach and neither does it involve an extensive investment management team. Due to these reasons, passive portfolio management subjects the investor to lower costs.

By using a buy and hold approach, index fund investors can earn market returns over a period. Most passive investors typically believe that there is no way to beat the market as it is impossible to do so.

Therefore, passive investors choose to invest in index funds, allowing them to earn market returns over a span of time.

Another characteristic of passive management of an index fund is that it also aims to reduce and eliminate risks associated with individual stocks, sectors, and especially human error. This results in a risk that is only associated with the broad market risk.

 

The difference between buying index funds and individual stocks

For an average investor, it would be riskier to buy an individual share than buying a diversified index fund. When buying a single stock, the entire portfolio directly correlates to one company. This means that the investor is carrying substantial risk when investing in a single company, known as a business risk.

Business risk is all the risks that are associated with one individual company, including constraints, product line issues, management mistakes, or changes in the capital structure.

It is for this reason that investors opt for a broad market fund or an index fund. With an index fund, investors make use of the power of diversification to reduce business risks as they hold a variety of businesses, meaning that one single holding has less impact on the entire portfolio.

 

How to get started in investing in an index fund

When starting in the world of investing, it may be a tedious and intimidating concept, however, there are many ways to get started. Most large banks offer their clients the option of investing in a variety of financial assets, including asset funds.

Numerous brokers offer traders and investors the opportunity to choose from some of the most popular indexes in the world. It comes down to the investor choosing which index they would like to invest in, choosing the right fund, and buying index fund shares.

 

How to choose an index fund

Investors must evaluate the following crucial factors before they buy an index fund:

  • Risk Tolerance – which involves the risk that the investor is willing to take for the anticipated return, the specific risks associated with the fund, and whether the strategy of the fund will fit the investor’s investment goals.
  • Fees – which relates to how much the investor pays for buying, owning, and selling the fund. By comparing funds that cover the same sector, investors can effectively compare costs.
  • Time horizon – which involves how soon the investor will need the money from returns.

 

Pros and Cons

✔️PROS ❌CONS
There is dependable performance Lack of flexibility
Lower costs involved Index funds rarely outperform the index
Transparency There may be tracking errors
Simple diversification Differences in management

 

Author Details

Louis Schoeman

Louis Schoeman

Featured Forex and Stocks writer

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