Investment strategies can seem overwhelming and intimidating at times. It’s hard to know where to start, what strategies will work best for your financial goals, and how to make sure that you are making the most of your money. Read on to learn more about what index funds are and 4 reasons why you should consider investing in index funds.
One strategy that is both simple and effective is investing in index funds. I’ve always been interested in learning how to grow my money and build wealth. Over the years, I’ve read books like The Automatic Millionaire and The Simple Path to Wealth. These books make it seem like investing for the long-term and building wealth are possible and it’s all thanks to an investment strategy called index funds.
What Are Index Funds?
An index fund is a type of mutual fund or exchange-traded fund (ETF) that typically mirrors the performance of a particular stock market index, such as the S&P 500 or Dow Jones Industrial Average. That means that instead of having an individual investor actively managing the assets, the index fund simply replicates the performance of its underlying stock market index.
As a result, it’s investors benefit from any appreciation or depreciation in its holdings. This also makes it relatively easy to understand and track, making it an attractive option for investors who want a low-maintenance way to invest their money without having to worry about actively managing their portfolio.
A popular example of an index fund is Vanguard’s S&P 500 ETF which basically allows you to invest in stocks representing 500 of the largest U.S. companies. You can start investing in some index funds with as little as $1 making it a low-barrier investment to start with.
Now that we know what these investments are, let’s talk about the 4 reasons to consider investing in index funds.
1. Low Fees
One of the biggest advantages of investing in index funds is that they typically have very low fees. Many index funds charge an annual fee (a.k.a. an “expense ratio”) that’s well under 1%. This means that you’ll be able to keep more of your profits instead of paying them out in fees.
These fees typically come out automatically and are deducted from your portfolio balance or taken from dividends. The Fidelity ZERO Large Cap Index actually has a 0% expense ration making it a very economical investment vehicle. Of course, your fee amount may increase as you invest more money but it’s still not much compared to other investments.
For example, a 0.03% expense ratio on a $10,000 investment in index funds will only cost you $3 per year. A 0.095% expense ration on the same amount will cost you $9.95 per year.
Another reason to consider investing in index funds is due to diversification. Index funds provide a high level of diversification typically at a low cost. By investing in an index fund, you’re essentially buying into hundreds (or even thousands) of different stocks all at once, reducing your overall risk while still getting exposure to the entire market.
Some see this as a much safer option than picking individual stocks. There’s often no telling which stocks will do well and which ones won’t at certain times. If you invest all your money into one or just a few stocks, you put yourself at a much higher risk. Compare this to creating a diverse portfolio by investing in hundreds of different companies with index funds.
When a particular stock goes down, you have other options to rely on and those lower stocks can even get replaced over time with new companies.
3. Long-Term Growth Potential
Index funds also have the potential for long-term growth because they are designed to track the performance of certain indices over time. If you invest in an S&P 500 index fund, for example, you will be exposed to some of the largest and most successful companies in America—and as these companies continue to grow and expand their operations, so too will your investment portfolio.
Also, index funds are the best option for people looking to invest for the long term. Since the market always goes up over time on average, you can experience more growth and compound interest by holding onto your investments. In other words, this is an ideal option if you’re not looking to constantly sell and trade stocks.
4. Passive Management
Finally, you should consider investing in index funds due to the passive management aspect. Index funds require little active management on your part. Having to constantly monitor prices and make individual trades can be time-consuming and expensive.
With index funds, you can simply buy into an existing basket of stocks. Then, just let your investments sit and grow overtime. Some robo advisor platforms, like Betterment and Wealthfront, even manage your investments for you. You just need to identify some goals and your ideal risk level. Then, the robo advisor will reinvest dividends and balance your portfolio on your behalf.