What’s an Index Fund

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What if you wanted to find the easiest possible way to enter the stock market? What if you didn’t want to or know how to do detail research on a company? What if you wanted to diversify with the purchase of one financial instrument? What if you didn’t want to pay high fees? What if I said, “yes you can do that”? Well guess what, that’s what I’m saying, YES you can do that….with index funds!

 

My Introduction to Index Funds

An index fund invests in a whole bunch of companies. An index fund has low fees. An index fund is called an index fund because it follows a stock market index such as the S&P 500 (just look at all the different types of companies within the S&P 500 index: S&P 500 Companies). One example is the Vanguard Total Stock Market Index Fund (symbol: VTSMX). Take a look at this screenshot (click to expand) of its largest holdings as of 12/31/16 (source: Example Vanguard Fund):

As you can see from the right-side, it invests in a lot of major companies (we’ve probably all heard of these 10 companies). On the left side, a decent chunk of the investments is in the financial sector. Also on the upper right-side, you can see that there’s a whole lot of $$$ invested by people into this fund (please note I am not promoting this fund or have any personal or financial gain from communicating about it). I just picked it as an example for this post because it said Total Stock Market Index Fund.

 

Are Index Funds Risky?

There are some risks to an index fund. One per Kiplinger is that they buy high. When a new stock enters into an index, which can happen several times a year, the stock price typically jumps 10%. This brings another risk that the index you are investing into may not be as fixed as you think. The S&P 500 has about 20 plus changes in companies in and out of the index per year leading to increased transaction costs: Kiplinger on Index Funds.

 

You may also believe there is a risk of not having control of what is contained in the fund. For example, if you are in an index fund and one of the companies is such you’ve always had a bad experience working with, don’t believe in their product/service, used to work for them but they screwed you over, or whatever reason, you don’t have a say in owning them if you are invested in the fund. Wait, am I taking this to a personal level….hmmmm maybe. We all have had a bad experience with a company. But let me say something else. That doesn’t mean that the company is not good or you should not invest in it. Don’t let investing become personal. Just look at the facts, numbers, senior management profile, projections, and so forth.

 

Is It Worth It to Buy Index Funds?

For most of us, yes, it’s worth it to invest in index funds. You get automatic diversification which means you spend less time researching the pros and cons of individual stocks, the fees are lower, you can trade them through an online brokerage like Scottrade (https://www.scottrade.com/) or Robinhood (thru your smartphone: https://www.robinhood.com/). Also, you have fewer ups and downs as that compared with buying bare stocks, which means less risk, but possibly less reward too as index funds may not rise as fast at stocks.

 

Sticking with the example of Vanguard’s index fund above, its largest holding is Apple (AAPL). Per the Google Finance chart below, AAPL has jumped about 20% from Mid-January till now, but the Index fund has remained fairly steady – click to expand.

 

If you do decide to invest some money in index funds, don’t worry you are definitely not alone. Per Investopedia “[f] or the 12-month period ending May 2016, investors poured more than $375 billion into index funds across all asset classes.

 

Most of that money came at the expense of actively managed funds, which experienced outflows of roughly $308 billion during the same time frame.” The reason was that index funds did better than actively managed funds in recent years. It goes to show that it’s sometimes just better to leave something alone and let it grow.

 

So what are your thoughts about index funds? Please share by commenting below.