As you begin to build your portfolio of investments, you will find that there are many ways to approach investing. Some require a significant amount of time and involvement, while others are more passive.
Before putting a significant amount of money into a portfolio, it’s important to figure out what your investment goals are and to learn about the many possible investment options.
One popular type of investment is called index investing, and as with any investing, there can be benefits, but there also may be risks. In this article we will go over what index investing is and how best to use this investing strategy.
An index fund is a mutual fund or exchange-traded fund which aims to mimic the overall performance of a particular market. The fund includes multiple stocks or bonds from the market and can be bought and sold like it’s a single investment.
There are index funds for the U.S. bond market, the U.S. stock market, international markets, and others. Index investing is the process of investing in these index funds.
Active investing typically involves in-depth research into each stock purchase, as well as regularly watching the market in order to time buys and sells. Passive investing strategies either aim to bring in passive income or to grow a portfolio over time without as much day-to-day involvement. Index investing is a passive strategy which looks to match the returns of the market it seeks to track.
Index investing started in the 1970s, when economist Paul Samuelson claimed that stockpilers should go out of business. Samuelson claimed that even the best money managers could not usually outperform the market average.
Instead of working with money managers, Samuelson suggested that someone should create a fund that simply tracked the stocks in the S&P 500.
Two years later, struggling firm Vanguard did just that. The fund was not widely accepted, and neither was the concept of index funds. Index investing has only become widely popular in the past two decades as data continues to reaffirm its merits.
Index investing has been gaining in popularity in recent years. Out of investments in mutual fund assets, the percentage allocated to index funds grew from 11 percent to 25 percent between 2006 and 2016. In 2017 investors withdrew $191 billion from U.S. stock funds and invested $198 billion into U.S. stock fund indexes.
Popular Indexes Include:
• S&P 500 Index
• Dow Jones Industrial Average
• Russell 2000 Index
• Wilshire 5000 Total Market Index
• Bloomberg Barclays Aggregate Bond Index
Popular Index Funds Include:
• Vanguard S&P 500
• T. Rowe Price Equity Index 500
• Fidelity ZERO Large Cap Index
• SPDR S&P 500 ETF Trust
• iShares Core S&P 500 ETF
• Schwab S&P 500 Index Fund
The Pros of Index Investing
Can Be Easier to Manage
Although it may seem as though active investors have a better chance at seeing significant portfolio growth than index investors, this isn’t necessarily the case. Day trading and timing the market can be extremely difficult, and may result in huge losses or underperformance.
The average investor typically underperforms the stock market by 4-5%. Active investors may have one very successful year, but the same strategy may not work for them over time. A 2013 study showed that index investing outperformed other strategies up to 80-90% of the time.
Lower Cost of Entry for Multiple Stocks
If you only have a small amount of money to start investing and you choose to invest in individual stocks, you may only be able to invest in a few companies. With index investing, you gain access to a wide portfolio of stocks with the same amount of money.
Also, index investing doesn’t necessarily require a wealth manager or advisor—you can do it on your own. The taxes and fees tend to be lower for index investing since you make fewer trades, but this is not always the case. Always be sure to look into additional fees and costs before you make an investment.
One of the key facets of smart investing is diversifying your portfolio. This means that rather than putting all of your money into a single investment, you divide it up into different investments.
By diversifying, you may lower your risk because if one of your investments loses value, you still have others. At the same time, if an investment significantly goes up in value, you still typically benefit.
Index funds give you access to a large number of stocks all within a single investment. For example, one share of an index fund based on the S&P 500 can give you exposure to up to 500 different companies for a relatively small amount of money.
Index Investing is Fairly Passive
Once you decide which index fund you plan to invest in and how much you will invest, there isn’t much more you need to do. Most index funds are also fairly liquid, meaning you can more easily buy and sell them when you choose to.
The Cons of Index Investing
Although there can be upsides to investing in index funds, there can also be downsides and risks to be aware of.
Index Funds Follow the Market
Studies have shown that investors don’t always understand what they’re investing in when it comes to index funds. 66 percent of investors think that index funds are less risky than other investments, and 61 percent believe that index funds help to minimize portfolio losses. However, index funds track with the market they follow, whether that’s the U.S. stock market or another market. If the market drops, so does the index fund.
Index Funds Don’t Directly Follow Indexes
Although index funds generally follow the trends of the market they track, the way they’re structured means that they don’t always directly track with the index. Since index funds don’t always contain every company that’s in a particular index, this means that when an index goes up or down in value, the index fund doesn’t necessarily act in exactly the same way. This is why it’s important to understand how specific index funds seek to track their underlying index.
Index Investing Is Best as a Long-Term Strategy
Since index funds generally track the market, they do tend to grow in value over time, but they are certainly not get-rich-quick schemes. Returns can be inconsistent and typically go through upward and downward cycles.
Some investors make the mistake of trying to time the market, meaning they try to buy high and sell low. Investing in index funds tends to work the best when you hold your money in the funds for a longer period of time or dollar-cost-average (e.g. invest consistently over time to take advantage of both high and low points).
Choosing an Index to Invest In
The name of a particular index fund may catch your eye, but it’s important to look at what’s inside an index fund before investing in it. Determine what your short and long term goals are and what markets you are interested in being a part of before you begin investing.
There are both traditional funds and niche funds to choose from. Traditional funds follow a larger market such as the S&P 500 or Russell 3000. Niche markets are more focused and may contain fewer stocks.
They may focus on a particular industry. Typically, a good way to start investing in index funds is to add one or more of the traditional funds first, then add niche funds if you feel strongly about their growth potential.
Index Funds Are Weighted
Depending on which index fund you invest in, it may be weighted. For example, the S&P 500 index is weighted based on market capitalization, meaning larger companies like Amazon and Facebook hold more weight than smaller ones.
If Facebook’s stock suddenly goes down, it may be enough to affect the entire index. Other indexes are price weighted, which means companies with a higher price per share will be weighted more heavily in the index. Another form of index weighing could be equal-weight or weights determined by other factors, such as a company’s earnings growth.
If you actively invest in individual stocks, you can usually choose exactly how many shares you want to buy in each company. But when you invest in index funds, you have less flexibility. If you’re interested in investing in a particular industry, there may not be an index fund focused solely on that.
How to Get Started With Index Investing
In order to invest in an index, investors typically purchase exchange-traded funds (ETFs) which seek to track the index. Some funds include all the assets in an index, while others only include particular assets.
Prior to investing in any particular index fund, be sure to look into the details of how the fund works. You can find information about what is contained in the fund, how it is weighted, its fees and quarterly earnings, and other details on the fund’s website, through your financial advisor, or EDGAR , the Electronic Data Gathering, Analysis, and Retrieval system that is overseen by the U.S. Securities and Exchange Commission.
Alternatives to Index Investing
Despite the fact that index investing has grown in popularity over the past two decades, some analysts are now bringing up additional downsides and alternatives which investors may want to consider.
The stock market includes companies from many different industries, some of which investors are moving away from investing in. Oil and gas companies, pesticide companies, and others which some people may consider harmful to the environment or human populations may be included in an index fund.
As the economy moves away from these industries, these types of companies may not perform as well, and as an investor you may not want to financially support them.
Some new index funds are being formed around the principles of sustainability and positive impact. You may also be interested in impact investing and other types of ETFs and mutual funds which focus on specific, positive industries.
Active stock portfolio management has been showing stronger performance over the past two years. This shift is partly due to the fact that certain industries are performing much stronger than others, and stock pickers can account for that as they build portfolios.
Investors in index funds may also see a downturn in coming years if the U.S. experiences a bear market.
Building Your Portfolio
Whether you’re interested in investing in index funds or in hand-selecting each stock, it’s important to keep track of your portfolio and current market trends.
Once you know what your investment goals are, SoFi Invest® can be a great tool to build your portfolio and track your finances. With SoFi Automated investing, you can easily add index fund ETFs to your portfolio, all on your phone.
The automated investments are pre-selected for you, so you simply need to decide which funds to invest in, and how much you want to invest. Or, if you prefer to hand-select each stock in your portfolio, you can use the SoFi Active Investing platform.
SoFi has a team of credentialed financial advisors available to answer your questions and help you reach your goals. The SoFi platform has no transaction fees, and you only need a $1 to get started.
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