Too chicken to buy Apple stock? Can’t come up with $3,100 for one share of Amazon? Eyeing other highfliers like Facebook or Netflix, too? Well, there’s an easy, cheaper, and less-risky way to buy all these leading stocks in a single investment.
It’s called an index fund.
They aren’t sexy. They’re not run by fund managers you see on TV talking about the stocks they think will double – or ones they think will crumble. Index funds are diversified mutual funds whose holdings mirror a broad stock index, such as the S&P 500. They are the antithesis of putting all your eggs in one basket.
Instead of buying individual stocks on your own, you can buy a large basket of stocks all at once, such as all 500 large-company stocks in the S&P 500. If you’re performance-chasing, however, the best you can do with an index fund is match the returns of “the market” (minus a small fee) or the index the fund tracks. And while that means you can’t brag to friends that you “beat” the market, your returns won’t be worse than the market, either.
Index funds are considered a “passive” way to invest, versus buying so-called actively managed funds run by a stock-picking portfolio manager whose goal is to post bigger returns than the market benchmark against which he or she is measured.
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To learn more about index funds, USA TODAY caught up with Ricardo Pina, founder of The Modest Wallet; Larry Swedroe, chief research officer at Buckingham Wealth Partners; and Jeff Carbone, managing partner for Cornerstone Wealth Group.
Below are answers to key questions related to investing in an index fund:
What is an index fund?
“An index fund is a type of mutual fund or ETF (exchange-traded fund) designed to track the performance and returns of a particular market index,” Pina says. “It is a portfolio of stocks, bonds, or other securities created to mimic the composition of a market index.”
How do index funds determine a stock’s weighting?
Most index funds determine how big a weighting (or ownership position) they will have in a stock by the size of its market capitalization, or market value. The bigger the market cap, the bigger the weighting a stock will have – and the bigger impact it will have on the index’s performance, Swedroe explains.
Apple, which recently became the first publicly traded company to surpass a market capitalization (stock price times shares outstanding) of $2 trillion, had a 7.21% weighting in the S&P 500 as of Aug. 21, according to Howard Silverblatt, senior index analyst at S&P Dow Jones Indices. As of that date, the 10 most valuable companies in the S&P 500 accounted for nearly 29% of the index. That top-heaviness is a big reason why when the biggest companies like Apple, Facebook, Amazon and Microsoft are rallying, the S&P 500 tends to go up as well.
There are also “equal weight” indexes in which an equal amount of money is invested in each stock, meaning each company has equal importance when it comes to performance.
How does an index fund differ from an actively managed fund?
“Index funds do not use any judgment,” Swedroe says. “The index fund holds all stocks in an index while an actively managed fund chooses which stocks it will buy and sell and holds them according to their beliefs about future returns.”
Managing index funds also doesn’t require a lot of operating costs, whereas actively managed funds incur higher expenses and hence have bigger expense ratios, Pina adds.
There are index funds of all flavors. Explain
While many of the largest index funds track the S&P 500, virtually every stock index and sector, as well as other financial asset classes, can be purchased in an index fund.
“There is a wide variety of index funds available, ranging from total market index funds (that basically invest in every U.S. stock traded on Wall Street) to socially responsible index funds,” Pina says. “Some of the most popular index funds include international, bonds, dividend-focused, sector, and real estate.
“When choosing a flavor, it is important to have an understanding of what your investment goals are.”
What are the key benefits of investing in an index fund?
Index funds are a low-cost way to invest your money and get broad market exposure, Swedroe says.
“They have low expense ratios, low turnover resulting in low trading costs and tax efficiency,” Swedroe says.
Another plus: Index funds are an easy way for people who lack market savvy to invest their money to meet long-term goals like retirement. Index funds take all the investment decision-making out of your hands.
“The ‘Keep It Simple, Stupid!’, or KISS, method works best – simplicity, transparency and cost are the key benefits,” Carbone says. And if you own an S&P 500 fund, which pretty much is the “market,” you can check the performance of the index on any day and “reasonably assume that you performed in-line with the S&P 500 index.”
Performance of index funds has been much better than most funds run by portfolio managers over the past decade.
“The results of several studies have shown that there is a long-term advantage of passive investing over active investing,” Pina says. “Investing in index funds is highly recommended for long-term investors.
Can you build a diversified portfolio with little money?
The answer is ‘yes’, Pina says. “A combination of a stock and bond fund might make the most sense in terms of diversification,” he says. ”For example, you can put your stock allocation into Vanguard Total World Stock Index Fund (VTWAX), while the portion allocated to bonds can go into Vanguard Total Bond Market Index Fund (VBTLX).
What are some cons of index funds?
An index fund that owns stocks doesn’t always go up. If the market or slice of the market your index fund tracks falls in value, your investment will also decline.
“While investing in index funds during the bull market has been proven to be a good investment strategy, it can however leave you vulnerable and unprotected to the downside of the market,” Pina says. “Index funds may be considered low-risk (due to their diversification), but that doesn’t mean there is no risk associated with them.”
Is an index fund a good option for my 401(k)?
If you take what Warren Buffett says to heart (the billionaire investor is a huge fan of low-cost index funds), you’ll realize that index funds are a good way to go, especially if you’re a hands-off investor.
“Index funds should be one part of the bigger picture in your 401(k) account,” Carbone says. “This allows one segment of your portfolio to have general broad market participation, and leaves flexibility to own other areas of the market (such as tech) that could yield superior returns to the broad index.”
For investors who aspire to build a sizable nest egg, “index funds make a lot of sense as an easy way to build retirement savings while minimizing fees and taxes,” Pina adds.
This article originally appeared on USA TODAY: Retirement planning: Index fund basics for investors