A passive investment method achieved by investing in an index fund
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What is Index Investing?
Index investing is a passive investment method achieved by investing in an index fund. An index fund is a fund that seeks to generate returns from the broader market by tracking an index. The S&P 500 is the most popular index to track, with a historical annual return of 10%.
Summary
- Index investing is a passive investment method achieved by investing in an index fund.
- The benefits of index investing include low cost, requires little financial knowledge, convenience, and provides diversification.
- Disadvantages include the lack of downside protection, no choice in index composition, and it cannot beat the market (by definition).
- To index invest, find an index, find a fund tracking that index, and then find a broker to buy shares in that fund.
Understanding Index Investing
Index investing falls under passive investing, which involves a buy-and-hold strategy for the long term. On the other hand, active investing is concerned with frequent buying and selling, coupled with continual monitoring of performance.
Exchange-traded funds (ETFs) are the security of choice when index investing. It is because ETFs are passively managed, and therefore low cost – the perfect medium for an index fund.
Advantages of Index Investing
Warren Buffet once said, “A low-cost index fund is the most sensible equity investment for the great majority of investors,” and it’s clear to see why.
- Low cost: Because index funds take a passive approach tracking an index, it has lower management fees than an actively managed fund
- Requires little financial knowledge: Index investing is relatively easy compared to building your own portfolio
- Convenience: Index funds contain hundreds of stocks that would be incredibly hard to replicate at an individual level
- Diversification: Holding a large array of stocks diversifies away idiosyncratic (firm-specific) risk
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)
How to Start Index Investing
Step 1
The first step to index investing is choosing the right index for your preferences. As mentioned, a common index to track is the S&P 500, an index composed of 500 large U.S. companies. Other popular indexes include the Dow Jones Industrial Average (DJIA), a composite of 30 US large-cap companies, and the NASDAQ Composite, another U.S.-based index that is heavily weighted in the IT sector. The U.S. market is often used synonymously as the broad market because of its importance and influence as a financial hub.
For individuals with more advanced financial knowledge, index investing can be a very useful tool to potentially “beat the market.” If you expect a particular region, sector, or factor to outperform, you can choose to invest in an index that specializes in such areas. For example, if you expect Asia to outperform in the future, you may look into tracking an Asian index. Popular indexes include:
- Shanghai SE Composite Index (China)
- Hang Seng Index (Hong Kong)
- Nikkei 225 (Japan)
The stock market is comprised of 11 sectors, formally known as the Global Industry Classification Standard (GICS). Such sectors include IT, healthcare, consumer discretionary, energy, industrials, and more. There are many available sector indexes that can be benchmarked.
Lastly, a factor is an attribute that’s been historically proven to provide excess returns across assets. Some identified factors include:
- Value
- Size
- Quality
- Momentum
- Volatility
- Growth
Each factor performs well at different points in the business cycle. If you feel confident of any specific factor, you can target it by buying into a factor index.
Of course, it should be noted that investing in a specific area will increase your risk. It is because if you choose to go overweight in a specific region/sector/factor and it ends up doing poorly, all your investments will suffer as a result. Nevertheless, higher risk comes with a higher return, so if you bet on a specific area that performs favorably, you can beat the broad market.
Step 2
The second step is to choose a fund that tracks such an index. There are many ETF providers that will have similar offerings with slight variations, so it is wise to do research into the differences. Such differences could be the expense ratio, dividend yield, performance, and more.
Step 3
The last step is to buy shares from your chosen index fund. To do so, you must open an account through a broker. Again, every broker may offer different benefits and drawbacks, so it is important to compare before jumping in.
More Resources
CFI is the official provider of the Capital Markets & Securities Analyst (CMSA)® certification program, designed to transform anyone into a world-class financial analyst.
In order to help you become a world-class financial analyst and advance your career to your fullest potential, these additional resources will be very helpful:
FAQs
Index investing is a passive investment strategy that seeks to replicate the returns of a benchmark index. Indexing offers greater diversification, as well as lower expenses and fees, than actively managed strategies.
Is investing in index funds a good idea? ›
Are Index Funds Good Investments? Index funds are very popular among investors. They offer a simple, no-fuss way to gain exposure to a broad, diversified portfolio at a low cost for the investor. They are passively managed investments, and for this reason, they often have low expense costs.
Is an S and P 500 index a good investment? ›
Investing in an S&P 500 fund can instantly diversify your portfolio and is generally considered less risky. S&P 500 index funds or ETFs will track the performance of the S&P 500, which means when the S&P 500 does well, your investment will, too. (The opposite is also true, of course.)
How risky is index investing? ›
Asset prices can rise and fall rapidly and investors must accept the fact that the value of their index based investment may fluctuate by as much as 50% or more in a year. General market risk can relate to a particular sector. For example, mining sector indices are usually more volatile than industrial sector indices.
What are 2 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)
For beginners, the vast array of index funds options can be overwhelming. We recommend Vanguard S&P 500 ETF (VOO) (minimum investment: $1; expense Ratio: 0.03%); Invesco QQQ ETF (QQQ) (minimum investment: NA; expense Ratio: 0.2%); and SPDR Dow Jones Industrial Average ETF Trust (DIA).
Do billionaires invest in index funds? ›
The bottom line is that even billionaires recognize the wealth-creation potential of low-cost index funds. Even if you're an active investor in individual stocks -- like Buffett and Dalio are -- rock-solid index funds like these four can help form an excellent backbone for your portfolio.
What if I invested $1000 in S&P 500 10 years ago? ›
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. $5,000 would grow to $16,498.
How much was $10,000 invested in the S&P 500 in 2000? ›
$10,000 invested in the S&P 500 at the beginning of 2000 would have grown to $32,527 over 20 years — an average return of 6.07% per year.
How much money was $1000 invested in the S&P 500 in 1980? ›
In 1980, had you invested a mere $1,000 in what went on to become the top-performing stock of S&P 500 (^GSPC 0.12%), then you would be sitting on a cool $1.2 million today. That equates to a total return of 120,936%. The stock? None other than Gap (GPS -0.73%).
Equity mutual funds experience market fluctuations in a short time. But over a longer tenure, market volatility is averaged out, which is unlikely in the short term. That's why it's prudent to align your long-term financial goals with index funds and stay invested for as long as possible.
Can you lose with index funds? ›
As with all investments, it is possible to lose money in an index fund, but if you invest in an index fund and hold it over the long-term, it is likely that your investment will increase in value over time.
How likely is it to lose money in a index fund? ›
Due to diversification and book value considerations, an index fund investor would almost never experience an absolute loss. Index funds are considered a relatively safe investment when compared to individual stocks.
Is it better to buy individual stocks or index funds? ›
Index funds often have lower fees than the costs incurred when trading individual stocks. If you are hiring a registered investment advisor for investing in stock individually it may cost you much more than investing in an index fund.
Why doesn't everyone invest in the S&P 500? ›
It might actually lead to unwanted losses. Investors that only invest in the S&P 500 leave themselves exposed to numerous pitfalls: Investing only in the S&P 500 does not provide the broad diversification that minimizes risk. Economic downturns and bear markets can still deliver large losses.
How many index funds should I own? ›
Experts agree that for most personal investors, a portfolio comprising 5 to 10 ETFs is perfect in terms of diversification.
What is a disadvantage to investing in index funds? ›
Challenges of Investing in Index Funds
However, an index fund does not have that flexibility as it has to be fully invested in the index at all points of time. While index funds are free from the fund manager bias, they are still vulnerable to the risk of tracking error.
Can you make good money from index funds? ›
Individual stocks may rise and fall, but indexes tend to rise over time. With index funds, you won't get bull returns during a bear market. But you won't lose cash in a single investment that sinks as the market turns skyward, either. And the S&P 500 has posted an average annual return of nearly 10% since 1928.
Is it better to invest in index funds or stocks? ›
One share of an index fund based on the S&P 500 provides ownership in hundreds of companies, while a share of Nasdaq-100 fund offers exposure to about 100 companies. Lower risk: Because they're diversified, investing in an index fund is lower risk than owning a few individual stocks.
What is the average return on index funds? ›
The average stock market return is about 10% per year, as measured by the S&P 500 index, but that 10% average rate is reduced by inflation. Investors can expect to lose purchasing power of 2% to 3% every year due to inflation. » Learn about purchasing power with the inflation calculator.
