Investing in Index Funds

One of the Best Ways to Invest Money

For many people, investing in index funds is a smart option to consider. It is a simple and frugal investing alternative when compared to building a portfolio of stocks or actively managed mutual funds.

Before discussing index funds, it is important to understand market indexes. A market index is comprised of a hypothetical grouping of stocks or bonds with similar characteristics. Its purpose is to track the performance of a whole market or a particular segment of it.

One of the best known indexes is the Dow Jones Industrial Average. It is comprised of the stocks of thirty large U.S. companies. There are many market indexes tracking everything from broad market averages to narrow segments of securities all over the world. The indexes serve as benchmarks to compare performances between various mutual funds and other groups of securities.

An index fund is a type of mutual fund or exchange-traded fund that is designed to closely match the performance of a particular market index. As with any investment in mutual funds, the fund invests in the securities of various companies. An index fund usually holds investments in all or almost all of the companies that are in the corresponding market index.

Of all the investment methods from which to choose, the index fund is a relatively straightforward and simple investing option. It is straightforward because at any given time you can know exactly what investments are in the fund. This is in contrast to an actively managed mutual fund where you may have no knowledge of the securities that the manager is buying or selling.

It is also simple to invest in index funds. First of all, you don’t have to spend time in researching and tracking companies as you would if you were selecting specific securities in which to invest. Likewise, you don’t have to investigate the performance, style, or fund manager as you would with a managed mutual fund. Finally, if you invest in a broad market index, you can know how your investments are doing each day by catching five seconds of news reporting about the markets.

The index fund is also a frugal investing option. There are at least three reasons why the costs of index funds are typically lower than actively managed funds:

1. Index funds are passively managed. There is no need for research on individual investments such as fundamental or technical analyses. Neither is there a need for analyzing market trends or sectors. That means the index funds typically don’t have to cover the expenses of a large staff of portfolio managers and stock analysts.
2. The transaction costs are minimal. The investment portfolio of an index fund is fairly stable, unlike more actively managed funds where there is often a great deal of buying and selling (also known as turnover) of the securities.
3. Taxes from capital gains are minimal. Again, because of the low turnover of securities in index funds, there are very few capital gains.

Please note that lower expenses are true of most index funds, but not for all. Before investing in any fund, always read the prospectus to fully understand the expenses.

With regard to performance, index funds may seem boring because they have average returns. In fact, they are meant to match the average for a particular group of securities. But, average is not so bad. Some actively managed mutual funds seem exciting because they generate huge gains at times. However, over time, most of them underperform the indexes which they use as benchmarks.

This is not to say that there aren't any good, actively managed mutual funds. There are many that have a great performance over the long run. You just need to do more research to find the right ones.

Investing in index funds is one of many great ways to invest money. If you are interested in low costs and simplicity, you may want to consider them as an addition to your portfolio.

Please be aware that this is general information and not meant to be investment advice for your situation. You can see a full disclaimer here.

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