Index funds allow investors to track the market in a low-cost, consistent way, according to most analysts and advisors.
An index fund provides exposure to a diverse selection of publicly traded securities that are intended to perform identically to a market index.
They don’t always perform in an exact 1-to-1 ratio, as we will see. But in general, most high-quality index funds perform in close lockstep with their underlying indexes.
How Can You Lose Money in an Index Fund?
Most financial experts agree that the biggest risk is not investing at all. While saving money is important, inflation steadily eats away at savings over time.
And at the time of this writing, interest rates are near 0%, with yields on most bonds actually less than the presumed rate of inflation, as measured by the Consumer Price Index.
All investments carry risk. An index fund, like anything else, can potentially lose value over time.
But most mainstream index funds are generally considered to be a conservative way to invest in equities (although there are lesser-known index funds that are thought to carry greater risk).
The main reason is that they are greatly diversified, distributing risk throughout many securities. Risk is also lowered by reducing an individual’s responsibility in managing the funds. Investors can simply buy and hold for years or even decades.
How Does an Index Fund Work?
Index funds are part of a growing trend of what’s referred to as “passive investments.”
Similar to an exchange-traded fund (ETF), an index fund is composed of many different assets packaged into a single security that investors can trade like a regular stock.
When you buy shares of an index fund, many people think you are almost buying a tiny piece of a share of every company in that index all at once. An S&P 500 index fund, for example, gives investors exposure to most 500 companies in the S&P 500, or so the story goes. And some index funds do work this way.
But in reality, things are not always so straightforward. The goal of an index fund is to track the performance of an index, and the fund can invest in any number of assets to achieve this end.
That often does include a substantial amount of holdings of the stocks contained in a specific index, but there can be other assets included as well.
Some funds might not actually hold any of the assets that are present in the index they are supposed to be tracking. Instead, they might invest only in derivatives, like options and futures, that are intended to perform similarly to the index.
Some funds also provide leverage, meaning they are designed to provide returns or losses greater than what their respective index provides. If a fund has 3x leverage, for example, then it might produce a return or loss three times as high as what its index does. Leveraged bets of any kind are generally considered to be riskier and more speculative.
How Likely Are Index Funds to Go to Zero?
Index funds are generally not as volatile as individual stocks because of their diversification. But of course, if the underlying index is volatile, then the index fund will be, too, assuming it tracks the index’s performance well.
Investors who stick to well-established index funds that own real assets probably don’t have too much to worry about. But they aren’t 100% free of risk either.
Markets don’t go up or down in a straight line, so over the short term, funds will fluctuate. But index funds can provide a good option to gain exposure to broad swaths of the market without having to select individual stocks or manage a portfolio actively.
Although any index fund comes with risk of loss, like all investments, some funds may have a real possibility of losing a significant portion of investment capital. Leveraged funds and funds that invest in derivative products have a higher-than-average chance to produce suboptimal returns.
Over long periods of time, though, most indexes have seen large returns, as the large companies that are included in most indexes continue growing.
What Are the Benefits of Investing in Index Funds?
The benefits of index funds involve everything described so far. Low risk and high diversification provide an excellent way to grow wealth steadily over time. For this reason, index funds can be a reasonable option for most long-term portfolios.
For the most part, major index funds with an established track record don’t require much active management. That’s why they fall under the umbrella term “passive investments.” This is another reason why some investors like index funds: They don’t have to keep track of a bunch of different securities, their performance, or their latest news releases and company fundamentals.
Some Common Misconceptions About Index Funds
Not all index funds are created equal, and not all of them work in a simple, straightforward manner. While the general concept may be simple enough, in practice things don’t always work out the same way.
Here are a few notes about some of the most common misconceptions about index funds.
Index Funds Always Perform the Same
Sometimes, some index funds might provide returns less than the actual index they track. This can happen for a number of reasons. A high expense ratio, for example, might mean that there are hidden fees associated with owning the fund, making it more expensive.
To this end, it can be important for investors to make sure their funds won’t underperform. Index funds are generally a good way to minimize bad decisions, but only if someone chooses a fund that has broad exposure and low fees.
All Index Funds Are Low Risk
As mentioned, index funds tend to be on the lower end of the risk spectrum. But not all index funds are created the same. For investors looking for minimal risk, it might be wise to seek out a fund that directly owns shares of stocks, has the most diversification possible, and has a long-standing track record of performance that mimics its underlying index.
Index Funds Work Well As Short-Term Investments
In general, some advisors suggest that index funds ought to be held for at least five years, if not 10 or more.
Funds of this type don’t make for good short-term investments because they usually don’t move a lot over short time periods, and the fees/commissions involved tend to eat into the meager profits investors might gain.
There are certain leveraged funds and ETFs that are better suited to short-term trading, but we won’t get into those here.
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