A Beginner’s Guide to Index Funds
As a budding investor, you are often encouraged to index funds as a place to start your wealth-building journey. But how do you even begin to figure out which of the many, many index fund options is right for you? Let’s take a look at some of the basics of working with index funds to help you navigate.
As we explained earlier , an index fund is a collection of investments that you buy in one package. This package – the fund – tries to reflect a certain level of performance for this corner of the financial market. “Instead of choosing individual stocks of companies and researching those companies, you have access to a portfolio of stocks, bonds or other securities,” explains Anjali Pradhan, CFA and Investment Coach at Dahlia Wealth . Index funds can relieve the stress of choosing specific stocks, and they usually cost a lot less than other investment vehicles.
(A quick note on ETFs and index funds, because sometimes conditions change places: Pradhan explained that ETFs are traded on stock exchanges at prices that move per second, like stocks. Index funds, on the other hand, are traded as mutual funds and are priced by an investment firm once a day.)
Portfolio variety without the hassle
All index funds are of a ‘type’ so to speak, you can still diversify your portfolio within index funds. “Small, big, in any market that exists, there is a greater and greater chance of finding an index fund of some kind,” said Rand Spero, president of Street Smart Financial, a financial-only financial planner.
Types of index funds
Here are just a few of them:
- Common Stock Market: Covers a wide portion of the entire market, such as the Dow Jones Industrial.
- S&P 500: 500 companies indexed by the Standard & Poor’s Index (usually the largest in the US).
- Market capitalization: Companies are grouped by value. But they are also classified by size, so you get a group of companies on relatively similar terms. Motley Fool has a breakdown of companies into large, small, and others.
- International Markets: Index funds aren’t just for US companies. You can select funds that track international markets based on whatever criteria you are looking for (company size, location, etc.).
- Target Date Fund: You specify when you think you will retire and the fund picks a stock and bond mix that matches what it thinks is right for someone your age. “It’s one size fits all,” Spero said. “Need a hat? Here is the hat. But what’s in it? “This is not one fund,” he explained. Instead, index funds are included in this trust fund.
- Growth Index: These indexes have companies that are expected to grow faster than the market as a whole, says The Motley Fool .
- Value Indices: Consists of a company’s stocks that are trading at low prices relative to the company’s earnings.
- Socially Responsible Funds: Don’t want your investment portfolio to include spirits, gambling, or fossil fuels? There are various social and environmentally conscious foundations.
- Dividend-focused funds : Some funds take profits for the year and pay you a check for interest, Spero explained. (Others take money and reinvest it.)
- Sectoral Funds: Want to Focus on Real Estate? Entertainment companies? Retail? There is an index fund for every industry you are interested in.
How to get started with index funds
All of these options are good, unless they are stressful for you, because there are so many of them. But don’t let their diversity get in the way of investing in index funds.
“Start with the underlying core [index funds],” Spero said. “S&P 500, general market index. Keep it simple and clear and broad and don’t get too smart, ”he said.
Mable Nunez, founder of the educational company Girl on the $ Money , specializing on investing in the stock market, the proposed five indicators that should be noted before choosing an index fund. We’ve added our tips to each of her breakpoints:
Cost Ratio (look for those that charge less than 0.25% )
Performance over time: Highs and lows are fine, but make sure you are comfortable with these fluctuations.
Results Compared to Standard S&P 500 Fund (You can check it out on Morningstar )
Holdings: How does an index fund invest money? (Refer to the list above to make sure you are comfortable with the holdings)
Turnover Ratio: “How often are index fund stocks sold and replaced?” – said Nunez. “The lower the better. High turnover rates can equal significant costs, which are then passed on to the investor. “
After you’ve chosen an index fund (or two or three), remember to check your selection once a year. Your investment taste may change over time, and you may find that today’s good decision may not work for you in a few years.
Index funds are friendly to new investors, but they are not the only way to build wealth. “Don’t let them give you a false sense of security,” Spero warned. “This is not a lifeline,” he said. “This is a relatively good product to start the investment process, but not the final destination.”
In other words, index funds are important, but a store of value, such as your 401 (k) and emergency fund, is also important. It is important to build a diversified investment and savings strategy over time, but what is more important? Get started now , no matter how small your first step is.