You might have heard about how index funds and index fund investing are a great way to ensure that you have a diversified portfolio.
So what are index funds? An index fund is a portfolio constructed to track a market index. A stock market index is a group of stocks that measures the performance of the overall stock market or a specific segment. When you buy an index fund, you’re buying a small part of the entire stock market.
Index funds ensure that your portfolio is well diversified since you’re covering a large portion of the market rather than just a single company. Let’s take a look at the pros and cons of index funds.
Pros of Index Funds
Index funds are easy. You don’t need to do a whole bunch of grueling research to make sure you’re picking that single winning stock. By investing in index funds, you’re choosing a passive strategy that mirrors the market. You just ride along with how the overall market performs – which is almost always up over the long term.
Index funds have low costs. When compared with actively managed mutual funds, index funds have very low fees. Owning a portfolio of index funds will usually cost you 0.05% to 0.35% annually, while actively managed funds can easily charge more than 2% in fees.
Index funds are diversified: This is especially helpful for new investors uncertain about how to diversify their portfolio. Index funds are a great starting point since they reflect the proportion to which certain companies are represented in the market.
Cons of Index Funds
Index funds have low flexibility. There’s nothing you can do if there are companies that you don’t like in the index. You’re stuck with them for the simple fact that they’re part of the index. Also, for newer sectors like cryptocurrencies or shrooms, being tied down to an overall index can make you feel like you’re missing out on the gains that the sector leaders are enjoying.
Index funds have a relatively low reward (but also low risk). Index funds track the overall market so you can be fairly sure that you’ll be up over the long term. However, that also means that you’re not going to be getting rich off the next Tesla or Facebook stock boom since there are so many companies in the index.
What Index Funds to Invest in
With a quick search, you’ll see that there are lots of different stock market indices. If you’re new to investing, then we would suggest you start out with the S&P 500 index in the United States.
What is the S&P 500 Index? The S&P 500 is considered the best representation of the overall United States stock market since it tracks the performance of the 500 largest companies in the country. The earliest version of this index started in 1923 by tracking 233 American companies. Some of the biggest companies tracked on this index include Berkshire Hathaway, Visa, and Disney.
Another popular index is the NASDAQ in the United States. The NASDAQ Composite Index tracks over 2,500 stocks that are listed on the NASDAQ exchange. Some people prefer to use the NASDAQ-100 index rather than the full 2,500+ stock index as the NASDAQ-100 has over a 90% correlation with the overall NASDAQ Composite Index. Some of the biggest companies on the NASDAQ include Apple, Amazon, and Facebook.
The last one we’ll mention is the S&P/TSX index in Canada. This Index is the benchmark Canadian index, and covers about 70% of the total market capitalization on the Toronto Stock Exchange. The Canadian index is fairly well diversified, but is significantly influenced by commodity prices such as oil since Canada is a country that exports lots of natural resources. Some of the biggest companies on the S&P/TSX include Shopify, Suncor Energy, and TD Bank.
Now you know what index funds are, the next step is to understand how to invest in them. Luckily, it’s super easy to invest in index funds these days. We like the index funds by iShares or Vanguard as they tend to have very low fees, and do a great job of tracking their targeted index. Just do a quick google search, and you’ll be able to find the right fund symbol to buy through your broker.
Once you decide on the index you would like to invest in, you might also want to consider whether you want to buy the index through an ETF or mutual fund.
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