What are index funds?
An index fund is a basket of stocks. The basket is usually based on a market index, for e.g. S&P 500 which is basically based on top 500 companies traded on NYSE or Nasdaq. Similarly, we have Dow Jones Index which is a selection of 30 companies in US. An index fund basically has each of the stock based on the market cap of it in the index which the fund is tracking. Let’s say if in S&P500 index Apple has 7% market cap as compared to the total of all the 500 stocks, then every 1$ worth of the index fund will have 7% of fractional shares in Apple stock. So this way you are getting exposure to all companies in the S&P 500 index.
Advantages
1. Risk management/diversification
You are instantly invested in multiple companies across multiple industries with most index funds. This diversification helps you reduce risk compared to buying a few stocks. More the number of stocks across various industries smaller is your risk. You can easily afford to let one of the companies be bankrupt. At the same time you will probably also enjoy the returns from top companies in the index!
2. Self cleansing
An index fund usually doesn’t do any active buying and selling of stocks. The only time a stock position is sold from index is when the company falls of the index. For e.g. if a company goes bankrupt or performs so poorly that it is dropped off the S&P 500 index, that’s when the index also sells shares of that company. In its place a new company shows up and the index buys that company’s stock accordingly. So in this way bad companies are removed from the index and fresh new company is introduced into the index.
3. Low expense ratio
Since the index fund is a passive buyer and seller of stocks and there is no active fund manager that buys and sells stock. As a result of this the expense ratio(fees charged = amount invested* expense ratio/100 ) is usually way lesser as compared to hedge funds/other actively managed funds. This fees includes transaction commission costs, taxes etc and is charged annually. But for index funds usually its cheapest.
4. Takes less of your time
Index fund investing is the simplest easiest thing to do for most people. Doesn’t take too much of your time. Its like set it and forget it. Doesn’t need too much understanding its pretty self explanatory and is proven strategy to invest.
Disadvantages
1. Average/market returns
Since you invest in indexes, you get the index return. If the index went up by 8% in that year, then you also make 8% on your money. If It goes down by 2-3% then even your money goes down by 2-3%. However, don’t be discouraged by average market returns. Most investors loose money and cant even beat the indexes. There was a very famous bet between Warren Buffet and an active fund manager Ted Seides. Between performance of an index fund and an active fund of funds over 10 years. It concluded recently, and as expected Buffet won! You can read about it here.
2. Holding some bad apples/no control over holdings
When you own an index fund with many stocks, most of the times you know a few companies in that fund are performing poorly. Since its an index fund, you cannot do anything about it until the company in question goes bankrupt or gets dropped from the index based on the criteria of index. However, in reality even this is not so bad. Since I mentioned above this is just the process of self-cleansing and eventually you get new companies in the index.
So what index funds to buy?
Buying index funds is one of the best, easiest, simplest, proven strategies for investing. Usually total stock market index fund, bond fund and an international index fund is more than enough. That diversifies you across total universe of companies across the world. Here are some examples from Vanguard & Schwab:
| Fund name | Description | Expense Ratio |
| Vanguard Total Stock Market Index Fund (VTSAX) | All company stocks traded in US equity markets | 0.04% |
| Vanguard Total Bond Market Index Fund (VBTLX) | Bonds from US traded companies and US government | 0.05% |
| Vanguard Total International Index Fund (VTIAX) | Stocks from all over the world except for US market | 0.11% |
| Schwab Total Stock Market Index Fund (SWTSX) | All company stocks traded in US equity markets | 0.03% |
| Schwab US Aggregate Bond Index Fund (SWAGX) | Bonds from US traded companies and US government | 0.04% |
| Schwab International Index Fund (SWISX) | Stocks from all over the world except for US market | 0.06% |
Investing in index fund doesn’t need any understanding of industries, stocks or fundamentals etc. Historically stock market has grown at 8-10% per year. So its just simple math by investing in stock market over long term you are almost getting the same return every year. Makes the whole task of picking stocks to grow wealth easy, less complex. This definitely allows you to focus your time on family and hobbies all the while your money keeps growing. Depending on your age and risk tolerance its better to figure out a what percentage of your money do you want to be in stocks bonds and real estates and then buy index funds based on that. There are also other index funds for different sectors in business, real estates countries etc. Do your research before diving into those and keep an out on the fees.
Disclaimer: I am not a financial professional, and every person’s situation is different. This blog is personal opinion, not financial advice. You should thoroughly investigate and analyze any financial decision yourself before investing any money in any investment program.
