Economy Education Stocks

Intro to Index Funds

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You may have heard of the Dow Jones Industrial Average, the NASDAQ, or the S&P 500. These are called stock market indices, and they measure the U.S. economy’s health and performance through the stock market. As the American economy thrives, so do these indices. As the economy heads into a downturn, so does the stock market, and thus, the indices. Have you ever wondered whether you could buy these indices? In fact, you can, through a type of asset class called an index fund. In this way, you can effectively buy into the broader economy — for any country, or even market sector.

The Fundamentals

In the most simple sense, an index fund invests in a market basket of stocks and other equities. This “basket” can be comprised of anything, but the basket generally has a theme. There are index funds for Chinese stocks, index funds for only tech stocks, or index funds for retail stocks. For nearly any investing strategy, there is likely to be an available index or exchange-traded fund available to invest in. The idea of index funds was pioneered by a man named Jack Bogle.

There are many investment companies that provide different index funds. If you are familiar with the market, you likely know of Vanguard and Fidelity Investments, just to name a couple. These companies have fund managers to manage these mutual funds. However, such funds often come at a cost. There is typically an annual expense ratio that must be paid, though these fees are usually very small and negligible to the everyday retail investor.

The S&P 500 has its own index fund, ticker symbol SPY, or the SPDR S&P 500 ETF. This fund’s goal, according to the State Street SPDR site, is to “correspond generally to the price and yield performance of the S&P 500® Index.” Thus, this ETF has the same market basket of stocks that the S&P 500 has. The price movements of the S&P 500 will be reflected in your portfolio, through SPY.

Investing in America

On CNBC last week, Buffet stated that $10,000 invested in the S&P 500 index in 1942 would become $51 million today. This is clear confidence in the American economy. Just as I described before, index funds track different baskets of stocks and investments. Given the SPY’s tracking of American equities, investing in the fund would be justified under the prospect of a growing American economy. Buffet has long supported the usage of index funds as they are low cost and they give you exposure to a variety of industries that support the American economy.

Index funds provide excellent exposure to a diversified portfolio. For the everyday investor, lacking experience or knowledge with the stock market, index funds are excellent investments. The American economy is one of the strongest in the world and should continue to grow at healthy rates and dominate global markets for decades to come. The index fund will most likely provide you much better returns than those you would receive from a savings account in a bank.

Drawbacks

As a result of the large, diversified portfolio of most index funds, returns will be slow and steady. On good days, these indexes will increase anywhere from 0.7 to 1%, as the stock market tends to grow. These returns are much lower than those associated with growth stocks. You are effectively limited in your choices with index funds as you cannot buy a certain industry or sector and the vast array of investments will keep your returns limited.

This problem can be avoided by doing research on various companies and filling your portfolio with stocks that have high potential and lower risk. These are hard to find, which is why many simply choose index funds. However, if you can find the stocks that will have a great return on their price, leagues above the returns from the stock market as a whole, you have the potential to make much more money.

The problem of lower returns can also be fixed through riskier index funds. Examples of these funds include TQQQ, a triple leveraged ETF that tracks the NASDAQ. Investing in this indicates a tremendously bullish sentiment towards the American economy. But, if the economy does poorly, your losses will be amplified as well.

Conclusion

The reality is that not everybody has time to do extensive market research on companies. Researching fundamentals, exploring company management, and determining of company products will maintain a dominant industry share is difficult and incredibly time-consuming. Additionally, portfolios have to be managed and constantly supervised — if the company has earnings soon, or if a top executive has been fired, you may have to adjust your holdings. For these reasons, parking your money in index funds can save time and provide decent returns.

About the author

Co-founder, Managing Editor and Contributor at StreetFins | + posts

I'm an incoming Stanford student passionate about financial literacy. I cover topics from personal finance to global economic news.