Index funds are attractive for several reasons, including diversification and low expense ratios. In regards to the former, when you purchase shares of an index fund, you're exposed to all the stocks in an index. The idea is that stocks that are appreciating will make up for stocks that are depreciating.
Why Choose a Fund Instead of Individual Stocks
An index can be made up of hundreds to thousands of stocks. The average investor couldn’t afford to buy all of those stocks.Exchange-traded funds(ETFs) and mutual fundsthat follow an index can buy all those stocks because they have larger pools of money made up of the dollars of thousands of investors. When you buy even one share of an index fund, you own every stock in the index.
In addition, funds “weight” their purchases. This means they buy more of some stocks than others. This is because the index counts some stocks as more likely to affect the index than others. A good index fund will weight its purchases to the same degree the index does.
An index is much more likely to recover from a downturn than any individual stock. For example, an index fund tracking the S&P 500 in 2008 would have lost approximately 38%. However, that same index rose by 325% by the start of 2018.
Does that mean that someone can guarantee the stock market will always recover? No one ever makes that claim. Here is what we can say: It always has recovered. That does not mean it always will, but knowing it always has provides some reassurance. However, aperson with a shorttime horizonof, say, five years or less, could lose money in that time if the index drops. This is because that person can’t afford to wait several more years for it to recover. This is why index funds are best for long-term investors, those who intend to stay in the fund for 6-10 years or more.
Indexes for Sectors
Indexes such as the Dow Jones Industrial Average and the S&P 500 are designed to track the stock market in general. But, you can also invest in funds that track asector, such as oil, technology, finance, consumer goods, and on and on. Whatever sector you can think of, someone has made an index for it, and someone else has created a fund that follows that index. An investor who thinksa particular sector is likely to outperform the general market can buy a fund that tracks thatsector and still be diversified within the sector.
This leads to another way to diversify with index funds. When you invest in several sector funds, you may also be diversified. In other words, if your oil funddoesn’t do well, chances are another index fund will. So, not only are you diversified within each sector, but you are also diversified by having money in different sectors.
Make sure you know what each fund invests in so you don’t duplicate holdings. For example, investing in an oil fund would no doubt duplicate some of the stocks in an energy fund.
The Bottom Line
Professional money managers who run mutual funds study the markets daily and apply advanced skills and knowledge to their trades. Even with all that work, though, 80% don’t do as well as the market. If so many professionals get it wrong, aninvestor with less knowledge and time isn’t likely to beat the market either. An index fund will allow you to match the market’s returns without constantly trading and studying. This is the power of diversified investing through index funds.
FAQs
Indexes for Sectors
Is an index fund diverse enough? ›
Index investing will give you diversification, but that can also be achieved with as few as 30 stocks, instead of the 500 stocks that the S&P 500 Index would track. If you conduct research, you may be able to find the best value stocks, the best growth stocks and the best stocks for other strategies.
What is a good way to diversify your portfolio? ›
Here are some important tips to keep in mind to help you diversify your portfolio.
- It's not just stocks vs. bonds. ...
- Use index funds to boost your diversification. ...
- Don't forget about cash. ...
- Target-date funds can make it easier. ...
- Periodic rebalancing helps you stay on track. ...
- Think global with your investments.
The S&P 500 is considered well-diversified by sector, which means it includes stocks in all major areas, including technology and consumer discretionary—meaning declines in some sectors may be offset by gains in other sectors.
How to invest in index funds for beginners? ›
Here's how you can get started investing in index funds.
- Decide on Your Index Fund Investment Goals. ...
- Pick the Right Index Fund Strategy for Your Timeline. ...
- Research Potential Index Funds. ...
- Open an Investment Account. ...
- Purchase Your First Index Funds. ...
- Set Up a Plan to Keep Investing Regularly. ...
- Consider Your Exit Strategy.
An investor who thinks a particular sector is likely to outperform the general market can buy a fund that tracks that sector and still be diversified within the sector. This leads to another way to diversify with index funds. When you invest in several sector funds, you may also be diversified.
What are the big 3 index funds? ›
The passive index fund industry is dominated by BlackRock, Vanguard, and State Street, which we call the “Big Three.” We comprehensively map the ownership of the Big Three in the United States and find that together they constitute the largest shareholder in 88 percent of the S&P 500 firms.
How much of my portfolio should be in the S&P 500? ›
The greater a portfolio's exposure to the S&P 500 index, the more the ups and downs of that index will affect its balance. That is why experts generally recommend a 60/40 split between stocks and bonds. That may be extended to 70/30 or even 80/20 if an investor's time horizon allows for more risk.
What does a diverse portfolio look like? ›
Having a mixture of equities (stocks), fixed income investments (bonds), cash and cash equivalents, and real assets including property can help you maintain a well-balanced portfolio. Generally, it's wise to include at least two different asset classes if you want a diversified portfolio.
How to check if your portfolio is diversified? ›
Putting It All Together
- Ensuring your portfolio is taking advantage of all available sources of return.
- Finding the optimal mix of return sources given your unique life goals and/or desired risk level.
- Getting what you pay for: Avoid paying high fees for exposures that are commonly available.
Over the past decade, you would have done even better, as the S&P 500 posted an average annual return of a whopping 12.68%. Here's how much your account balance would be now if you were invested over the past 10 years: $1,000 would grow to $3,300.
How many index funds should I own? ›
A commonly cited rule of thumb is to own between 10 and 20 mutual funds, but the actual number will vary depending on your individual circ*mstances. Too many funds can lead to unnecessary over-diversification and overlap. There's really no point in owning, say, two index funds that invest in the same index.
Why shouldn't you just invest in the S&P 500? ›
Lack of Global Diversification
The S&P 500 is all US-domiciled companies that over the last ~40 years have accounted for ~50% of all global stocks. By just owning the S&P 500 you miss out on almost half of the global opportunity set which is another ~10,000 public companies.
What are two cons to investing in index funds? ›
Disadvantages of Index Investing
- Lack of downside protection: There is no floor to losses.
- No choice in the index fund's composition: Cannot add or remove any holdings.
- Can't beat the market: Can only achieve market returns (generally)
As with other mutual funds, when you buy shares in an index fund you're pooling your money with other investors. The pool of money is used to purchase a portfolio of assets that duplicates the performance of the target index. Dividends, interest and capital gains are paid out to investors regularly.
Is it OK to only invest in index funds? ›
Investing legend Warren Buffett has said that the average investor need only invest in a broad stock market index to be properly diversified. However, you can easily customize your fund mix if you want additional exposure to specific markets in your portfolio.
Is it okay to only invest in index funds? ›
Investing legend Warren Buffett has said that the average investor need only invest in a broad stock market index to be properly diversified. However, you can easily customize your fund mix if you want additional exposure to specific markets in your portfolio.
Is there a downside to index funds? ›
Disadvantages of index funds. While index funds do have benefits, they also have drawbacks to understand before investing. An index fund tends to include both high- and low-performing stocks and bonds in the index it's tracking. Any returns you earn would be an average of them all.
Do billionaires invest in index funds? ›
Even the top investors put their money in index funds. Some of the wealthiest people in the world are professional investors. Billionaires like Warren Buffett, Ray Dalio, Bill Ackman, and Ken Griffin have made their fortune by getting others to invest with them and making smart investments.
How diverse is the S&P 500? ›
S&P 500 Board Diversity Hits 50%: How We Got Here, Where We're Going - DiversIQ.
