12 Tips for Indices Investing
I nvestors have a multitude of options for what to do with their money in the stock market. One choice that’s proven time and again to be relatively low risk and successful is index investing. This strategy is one of the easiest out there, but you’ll want to do your homework before you invest. Consider these 12 tips for investing in indices to help you make the best choices and review a few classic stock index investing funds you might think about buying into.
- Index investing is a passive investment strategy.
- Investors track an index with a mutual fund or ETF.
- This strategy has advantages like low cost, simplicity, and low risk.
- However, it also has disadvantages like lack of flexibility and tepid performance.
- Research prior to investing is paramount.
What Is Index Investing?
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I ndex investing is a passive investment strategy that involves purchasing securities or funds that track an index. A stock index is a measurement of the overall stock market or a subset of the stock market to see its health and performance. You can’t invest directly in indices — they’re mathematical constructs, not funds. However, funds that track indices exist for investors interested in tracking the market.
How Does Index Investing Work?
Index investing works by investing in funds that generate returns that are reflective of the underlying index. Usually, index stock investing is relatively low risk but provides consistent returns. Investors have three options if they want to track an index with investments:
- Individual securities: The first option is to purchase each of the individual securities, both stocks and bonds, the index tracks. Not many people choose this method because, depending on the index, it can be costly and time-consuming.
- Mutual funds: Many mutual funds specifically track market indices. The investor’s money is pooled with other investors by a money manager who oversees the overall investment.
- Exchange-traded funds: Commonly known as ETFs, these funds function like mutual funds in their design, but trade like stocks. They’re often less expensive to manage than mutual funds.
Mutual funds and ETFs both fall under an umbrella called index funds. Generally, index investing is a passive pursuit, though some mutual funds can have an active money manager.
Active vs. Passive Investing
Active and passive investing can lead to a wide range of outcomes for the investor. Understanding the difference is key when you’re considering whether investing in indices is the right choice for you.
Active investing is a strategy in which investors track the stock market and make frequent, calculated trades to try and ‘beat’ the market. It takes a tremendous amount of knowledge and time and is usually pretty risky. However, if you make a good move, you could see super high returns. Active investing is most popular with serious investors and professionals.
Passive investing, by contrast, is simple. You purchase a security, and then you sit on it, usually for years, before selling your shares, hopefully at a profit. This passive approach has demonstrated higher efficacy historically than active trading since, over time, the market tends to go up in value. Indices investing is a passive strategy. Amateur investors or those with long-term savings goals tend to do more passive investing than active investing.
Advantages of Index Investments
Stock index investing has a number of advantages that make it a sound investment strategy for a variety of investors:
- Historical performance: Over time, passive investments tend to do better than active investments. Since index investing is a passive strategy, it follows that, in the long run, the investment should yield good returns.
- Low management fees: Passive management requires very little supervision and oversight, which means management fees are super low.
- Low expense ratios: Related to low management fees, the expense ratios for index investments are also low.
- Reduced taxes: The fewer the trades, the fewer the taxes. Since investors hold on to index investments for years without trading, they incur fewer taxes overall than active investors.
- Diversification: Mutual funds and ETFs are diversified investments since they’re composed of a multitude of securities.
- Reduced risk: The diversification and relative safety of the underlying assets leads to a low-risk investment.
- Consistency: You won’t be swayed by spikes and drops in the market since your entire strategy is to sit on your shares and wait until you need the money.
- Simplicity: You don’t need to constantly check the value or performance of your fund since you’re not doing any active trading. It’s easy to manage.
- Transparency: It’s easy to see how the fund is performing relative to the index since you know exactly what’s included in both.
Disadvantages of Index Investments
Despite their overwhelming positivity, index investments do have a few disadvantages for investors to consider:
- Expense: If you decide to invest in each security in the index individually, you could be out a lot of money.
- Time: Similarly, the time it takes to find each security in an index (which can represent thousands of companies) can take a lot of time.
- Weight: Mutual funds and ETFs might weigh some securities more heavily than others in the fund, which can lead to inconsistency in performance versus the actual index.
- Lack of flexibility: Mutual funds and ETFs don’t offer much flexibility compared to individual securities.
- Tracking error: The tracking error, or the difference in cost due to management fees, can vary greatly from fund to fund, leading to a lower overall return.
- Management: Try to find out who manages the index fund and who calculates the index itself. Occasionally you’ll find a conflict of interest, which could lead to a lack of transparency.
- Rare outperformance: While you can reasonably expect a positive return from an index fund over time, these funds rarely outperform the index they track.
Tips for Investing in Index Funds
If you’re ready to dive into index investing, use these 12 tips to help you find the best investment for your goals.
1. Pick the right fund
Make sure you choose a fund that matches your goals. Mutual funds and ETFs have distinct advantages and disadvantages regarding cost, management, and trading flexibility, so compare funds before making an investment.
2. Find a great brokerage service
If you’re investing in a diverse collection of securities, from traditional stocks to funds to options contracts, find a brokerage service that manages all types of investments. This will make it easier for you to manage your portfolio and compare performance.
3. Compare purchase options
Often, mutual funds are more expensive to maintain than ETFs, but they do offer more in the way of management. Consider the pros and cons of higher fees to slightly more active management before making any investments. Choose a fund with fees and oversight that makes sense for you.
4. Look for no transaction fees
Some brokerages offer transaction fee-free trading with mutual funds and ETFs. Look and see if that’s an option with your brokerage account, or consider opening an account with a brokerage firm that offers no transaction fees.
5. Assess the company
Learn about the companies, particularly those with the most weight in the fund, before you make your investment. Look at historical data to see information like how the company’s stocks have performed over time and what sort of dividends they provide (if they offer dividends).
6. Consider market cap
Market capitalization, or the category into which each company falls based on its size and revenue, can impact investments. Small-cap, mid-cap, and large-cap companies all offer advantages and disadvantages to investors, so knowing the general make-up of the fund’s capitalization can help you make an informed investing decision.
7. Look at the geography
Some index funds track foreign exchanges rather than the New York Stock Exchange. If you’re investing in forex index funds, make sure you’re following how the corresponding forex index has performed and how the underlying companies are doing.
8. Determine the sector
Some indices track specific industries or sectors, while others are more diversified. Sector-specific index funds can offer some advantages. For example, tech-based funds have been on the rise in recent years. However, should a major catastrophe impact the industry as a whole, your index fund will suffer.
9. Discover market opportunities
Similar to industry-specific funds, some new indices or emerging markets can offer a great potential investment. Do your homework, though, to ensure the risk of investing in something with little to no track record is safe enough for your investing goals.
10. Know your risk tolerance
Consider how risky you’re willing to go in your investment choices. Overall, tracking stock indices is a pretty safe investment bet, but depending on the industry, market cap, geography, and longevity, some are definitely safer than others.
11. Set your goals
Have clear and specific investing goals. Most investors who put money into index investing are looking to amass long-term wealth for retirement income rather than short-term income. Make sure your goals align with your investment choices.
12. Ensure it’s tracking the index
Check in periodically to make sure your index fund is reasonably tracking the index itself. Of course, they’re probably not going to be identical in value, but you want it to follow a similar trajectory for maximum return later.
Index Funds to Consider
Check out a few of the most popular index funds to see how they compare to your investment goals. Now, we’re not brokers or advisors, so use this information for research, not as recommendations for what to buy. As you’ll see, while each of the ETFs below tracks the same index, they each have slightly different returns.
Vanguard S&P 500 ETF
As the name suggests, this ETF tracks the S&P 500.
- Ticker: VOO
- YTD return: 4.42%
- 1-year return: 18.54%
- 5-year return: 70.96%
iShares Core S&P 500 ETF
This ETF, which also tracks the famed S&P 500, comes from iShares.
- Ticker: IVV
- YTD return: 4.51%
- 1-year return: 18.28%
- 5-year return: 70.12%
SPDR S&P 500 ETF Trust
SPY is one of the largest and most popular S&P 500 ETFs for investors.
- Ticker: SPY
- YTD return: 4.54%
- 1-year return: 18.51%
- 5-year return: 70.43%
Investing in indices is a solid strategy for long-term gains. Make sure you use these tips to perform effective research and find an index fund that works for your risk level and goals.