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What are index funds?
Index funds have been popular for many years now, but many people are still confused about them and wonder whether they are a good investment. Simply put, an index fund is a type of mutual fund that contains shares from multiple companies. They typically track a specific portion of the stock market, such as large companies, small cap (AKA small companies), or even the entire US stock market. Some well-known examples of index funds include the S&P 500 (a collection of 500 large companies) and the Russell 2000 (2,000 “small-cap” stocks). There are also index funds that track the major companies of specific countries, as well as regions made up of several countries.
Investors have the option of buying shares of individual stocks but the fewer companies they own, the more risk they are taking on. If, for example, your portfolio is composed of a single company and the company doesn’t perform well, you could lose a lot of money. Conversely, if the company grows substantially, you could earn a high rate of return on your money. Unfortunately, high performing companies are few and far between and finding the next Netflix can be tricky. Although many have tried to “beat the market”, very few investors have been able to consistently find high performing companies over the long run. Even a small number of losing stocks can significantly hurt an investor’s overall portfolio. Studies have consistently shown that the majority of investors will underperform the overall Stock Market in the long run. Thankfully, rather than buying shares of individual companies, investors can invest in an index fund which contains dozens -often hundreds- of companies. In addition to providing investors with diversification through broad market exposure, index funds tend to have low portfolio turnover and low operating costs. They also beat the majority of actively managed mutual funds. Since most index funds have lower fees than actively managed mutual funds, you are likely to make substantially more money over time. Even a 1% or 2% annual fee can cost you tens of thousands of dollars over your lifetime. Most, but not all, index funds charge significantly less than 1%. (Make sure to check the fees for any index fund you are considering.)
Risks and potential rewards
Like most investments, index funds are not guaranteed to go up in value. In fact, they will occasionally lose money, sometimes in significant amounts. Although the stock market has historically had an upward trend, there is no guarantee that this will always be the case. Inveduco believes that the market will continue to go up in the long run, but it is possible that a downward trend, also known as a secular bear market, could potentially last for many years. Unfortunately, there is little that individual investors can do to predict these market patterns or even to prepare for them but it is important to be psychologically prepared for such an occurrence and avoid letting fear drive us to take our money out of the stock market.
Although no investment is 100% safe, including index funds, everyone needs to build a nest egg to attain a certain amount of financial security and, ultimately, to achieve financial independence. Some risk-averse investors keep their money invested in “safe” investments (such as Government bonds or CDs) but these investment vehicles are unlikely to earn enough to build a significant nest egg in the long run. In fact, some of these investments won’t even beat inflation. Although risk is an unpleasant aspect of investing, a certain amount of risk is necessary and unavoidable.
How much should I invest in index funds?
Inveduco advises the average investor to invest at least 50% of their retirement portfolio in index funds. There are exceptions, such as retirees or investors with a low-risk tolerance (who simply won’t be able to sleep at night with such a high percentage of their portfolio invested in “risky” stocks). Generally speaking, the younger the investor, the greater the percentage of their portfolio should be invested in index funds as they have more time to recover from potential long-term market losses. Individuals in their 20s and 30s can –and should- invest a much larger share of their portfolio in index funds. One rule of thumb to determine what percentage of your retirement savings should be invested in stocks is to subtract your age from 110 or 120, depending on your risk tolerance. For example, if you are 30 years old, you should invest between 80% and 90% into stocks based on this rule. As people approach retirement, they should progressively decrease the proportion of their portfolio invested in stocks and increase their bond holdings.
One final piece of advice in regards to index funds is to avoid trying to time the market or making major changes to your asset allocation due to market fluctuations.