Have you ever wondered how index funds work, and whether you should invest in them on your journey to financial independence? Keep reading for more on what you need to know about index funds as a beginner investor.
What Is An Index Fund?
But first, the basics. An index fund is a group of stocks or bonds that track the performance of a particular index. For example, the S&P 500 index is made up of the top 500 US companies on the stock market. So if you have an S&P 500 index fund, that fund will invest in all 500 of those companies.
Sometimes you may hear index funds described as mutual funds. While technically index funds are mutual funds, they are actually a subcategory, because mutual funds include index funds and actively managed mutual funds - and there is a big difference between the two:
● Index funds track an index.
● Mutually managed funds are run by a mutual fund manager who decides what goes in and out of the fund.
This is an important point to remember when dealing with index funds.
What You Need To Know
These are ten things you need to know if you are considering investing in index funds.
1. Diversifying Your Investments
Index funds are a good way to invest if you only have a small amount of money available because it gives you automatic diversification. With $100 you might be able to invest in one or two stocks, but with an index fund, that same $100 gives you access to 100s of companies.
2. There Are Many Index Funds
When people think of index funds they tend to think of the stock market index or the aforementioned S&P 500, but many don’t realize that there are thousands of index funds to invest in.
If you’re planning to invest in an index fund, it’s important to know what your investing goals are so you can choose one that best aligns with those goals.
3. There Is More Variety Than You Think
With thousands of index funds on the market, you’ll find there are countless types of index funds available to you, from technology to healthcare to cybersecurity. There is plenty of flexibility in terms of what you can invest in, and you should take this into account when building your portfolio.
4. Don’t Believe The “Actively Managed Mutual Fund” Hype
When choosing a mutual fund, you may be considering either an index fund or the aforementioned actively managed mutual fund (AMMF). It will often be made to seem that an AMMF is better than an index fund because they have a fund manager, are more active, and are trading stocks virtually every day.
But historically an index fund has been shown to almost always outperform an AMMF. This is largely due to two things:
● AMMFs tend to be inconsistent when it comes to picking winning investments.
● AMMFs have higher fees.
Combine these two factors and you have low performance, especially compared to index funds.
5. Be Aware Of Fees
Always check the fees for index funds first. And when you do, make sure to check the expense ratios, which will vary depending on your brokerage company.
For example, the Wells Fargo S&P 500 index fund has an expense ratio of 0.45%, compared to the Vanguard S&P 500 which offers only 0.04, i.e an expense ratio that is ten times smaller for essentially the same index fund!
6. Minimum Investments
Be aware that some index funds require a minimum amount to start investing, and sometimes the amount can be discouraging. Vanguard, for example, has some of the highest minimum investment amounts to get started, whereas other companies will allow you to invest in their index funds with no minimum amount (Fidelity is a great example of this).
7. ETF Equivalents
Keep in mind that some brokerage companies will have an ETF equivalent to their index fund. Let’s go back to Vanguard. If you click on one of the many index funds on their website, that same page will also tell you if there are any ETF equivalents.
This is important to know if you want to invest in the index fund but maybe you can’t afford the minimum investment requirement, because the ETF equivalent will usually be at a much lower price.
8. Some Index Funds Pay Dividends
Dividends are profits that a company pays to its shareholders, and if you’re lucky the companies that your index fund invests in might do the same. That means you get to collect those dividends, reaping the rewards of your index fund upfront! Dividends are often paid out on a quarterly basis, which is especially helpful if you’re planning to rely on investments as part of your income.
9. More Tax-Efficient Than AMMF
Because AMMFs involve a lot of buying and selling, you might find that those transactions incur capital gains tax that is passed on to you, the investor. Index funds do not buy and sell as much, so taxes tend to lower.
10. Index Funds Are Usually Capitalization-Weighted
This means that when index funds invest in different companies, they won’t invest at the same percentage, i.e you are not going to get 1 or 2% of every company in the fund. Companies that have a larger capitalization, or value, in the stock market, are going to have a higher percentage owned in the index fund.
Investing in capitalization-weighted funds means you are investing more in bigger companies, like Amazon, Apple, and Facebook, because these are some of the biggest companies on the market. You will own a much smaller percentage of the smaller companies in your index fund.
This means that if you notice a drop in your index fund it is likely that those bigger companies have dropped in the stock market that same day.
Index funds can be a great investment option for you, but it's important that you know the details first. Hopefully, this info has given you enough insight into how they work, and whether they fit your investment strategy. For more information on index funds and stock market investing, check out more articles at Our Rich Journey.