A passive investment method achieved by investing in an index fund
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What is Index Investing?
Index investing is a passive investment method achieved by investing in an index fund. An index fund is a fund that seeks to generate returns from the broader market by tracking an index. The S&P 500 is the most popular index to track, with a historical annual return of 10%.
Summary
- Index investing is a passive investment method achieved by investing in an index fund.
- The benefits of index investing include low cost, requires little financial knowledge, convenience, and provides diversification.
- Disadvantages include the lack of downside protection, no choice in index composition, and it cannot beat the market (by definition).
- To index invest, find an index, find a fund tracking that index, and then find a broker to buy shares in that fund.
Understanding Index Investing
Index investing falls under passive investing, which involves a buy-and-hold strategy for the long term. On the other hand, active investing is concerned with frequent buying and selling, coupled with continual monitoring of performance.
Exchange-traded funds (ETFs) are the security of choice when index investing. It is because ETFs are passively managed, and therefore low cost – the perfect medium for an index fund.
Advantages of Index Investing
Warren Buffet once said, “A low-cost index fund is the most sensible equity investment for the great majority of investors,” and it’s clear to see why.
- Low cost: Because index funds take a passive approach tracking an index, it has lower management fees than an actively managed fund
- Requires little financial knowledge: Index investing is relatively easy compared to building your own portfolio
- Convenience: Index funds contain hundreds of stocks that would be incredibly hard to replicate at an individual level
- Diversification: Holding a large array of stocks diversifies away idiosyncratic (firm-specific) risk
Disadvantages of Index Investing
- Lack of downside protection: There is no floor to losses
- No choice in the index fund’s composition: Cannot add or remove any holdings
- Can’t beat the market: Can only achieve market returns (generally)
How to Start Index Investing
Step 1
The first step to index investing is choosing the right index for your preferences. As mentioned, a common index to track is the S&P 500, an index composed of 500 large U.S. companies. Other popular indexes include the Dow Jones Industrial Average (DJIA), a composite of 30 US large-cap companies, and the NASDAQ Composite, another U.S.-based index that is heavily weighted in the IT sector. The U.S. market is often used synonymously as the broad market because of its importance and influence as a financial hub.
For individuals with more advanced financial knowledge, index investing can be a very useful tool to potentially “beat the market.” If you expect a particular region, sector, or factor to outperform, you can choose to invest in an index that specializes in such areas. For example, if you expect Asia to outperform in the future, you may look into tracking an Asian index. Popular indexes include:
- Shanghai SE Composite Index (China)
- Hang Seng Index (Hong Kong)
- Nikkei 225 (Japan)
The stock market is comprised of 11 sectors, formally known as the Global Industry Classification Standard (GICS). Such sectors include IT, healthcare, consumer discretionary, energy, industrials, and more. There are many available sector indexes that can be benchmarked.
Lastly, a factor is an attribute that’s been historically proven to provide excess returns across assets. Some identified factors include:
- Value
- Size
- Quality
- Momentum
- Volatility
- Growth
Each factor performs well at different points in the business cycle. If you feel confident of any specific factor, you can target it by buying into a factor index.
Of course, it should be noted that investing in a specific area will increase your risk. It is because if you choose to go overweight in a specific region/sector/factor and it ends up doing poorly, all your investments will suffer as a result. Nevertheless, higher risk comes with a higher return, so if you bet on a specific area that performs favorably, you can beat the broad market.
Step 2
The second step is to choose a fund that tracks such an index. There are many ETF providers that will have similar offerings with slight variations, so it is wise to do research into the differences. Such differences could be the expense ratio, dividend yield, performance, and more.
Step 3
The last step is to buy shares from your chosen index fund. To do so, you must open an account through a broker. Again, every broker may offer different benefits and drawbacks, so it is important to compare before jumping in.
More Resources
CFI is the official provider of the Capital Markets & Securities Analyst (CMSA)® certification program, designed to transform anyone into a world-class financial analyst.
In order to help you become a world-class financial analyst and advance your career to your fullest potential, these additional resources will be very helpful:
FAQs
Over the long term, index funds have generally outperformed other types of mutual funds. Other benefits of index funds include low fees, tax advantages (they generate less taxable income), and low risk (since they're highly diversified).
Does index investing really work? ›
The Bottom Line. Index funds are a popular choice for investors seeking low-cost, diversified, and passive investments that happen to outperform many higher-fee, actively traded funds.
Is it okay to only invest in index funds? ›
Investing legend Warren Buffett has said that the average investor need only invest in a broad stock market index to be properly diversified. However, you can easily customize your fund mix if you want additional exposure to specific markets in your portfolio.
Is it possible to beat the index? ›
It is true that most investors don't beat the returns of the S&P500, but it's not true that they can't. For one thing, if you pick S&P500 stocks at random you have a 50% chance of beating the index before fees and taxes—and it's easy for individuals to keep fees and taxes below even the no-fee ETFs and mutual funds.
Do billionaires invest in index funds? ›
There are many ways to start investing, but one that's worked for billionaires like Warren Buffett is investing in low-cost index funds.
What are 2 cons to investing in index funds? ›
The benefits of index investing include low cost, requires little financial knowledge, convenience, and provides diversification. Disadvantages include the lack of downside protection, no choice in index composition, and it cannot beat the market (by definition).
Do index funds ever lose money? ›
So while it's theoretically possible to lose everything, it doesn't happen for standard funds. That said, an index fund could underperform and lose money for years, depending on what it's invested in. But the odds that an index fund loses everything are very low.
Why not just invest in the S&P 500? ›
The one time it's okay to choose a single investment
That's because your investment gives you access to the broad stock market. Meanwhile, if you only invest in S&P 500 ETFs, you won't beat the broad market. Rather, you can expect your portfolio's performance to be in line with that of the broad market.
Do index funds double your money? ›
According to Standard and Poor's, the average annualized return of the S&P index, which later became the S&P 500, from 1926 to 2020 was 10%. 1 At 10%, you could double your initial investment every seven years (72 divided by 10).
Why I don't invest in index funds? ›
Indexes are set portfolios. If an investor buys an index fund, they have no control over the individual holdings in the portfolio. You may have specific companies that you like and want to own, such as a favorite bank or food company that you have researched and want to buy.
Another reason some investors don't invest in index funds is that they may have a preference for investing in a particular industry or sector. Index funds are designed to provide exposure to broad market indices, which may not align with an investor's specific interests or values.
Is it smart to just invest in the S&P 500? ›
Investing in an S&P 500 fund can instantly diversify your portfolio and is generally considered less risky. S&P 500 index funds or ETFs will track the performance of the S&P 500, which means when the S&P 500 does well, your investment will, too.
Has anyone ever beat the S&P 500? ›
Yes, you may be able to beat the market, but with investment fees, taxes, and human emotion working against you, you're more likely to do so through luck than skill. If you can merely match the S&P 500, minus a small fee, you'll be doing better than most investors.
Is it better to buy S&P 500 or individual stocks? ›
Is Investing in the S&P 500 Less Risky Than Buying a Single Stock? Generally, yes. The S&P 500 is considered well-diversified by sector, which means it includes stocks in all major areas, including technology and consumer discretionary—meaning declines in some sectors may be offset by gains in other sectors.
What is the most successful index? ›
The most popular index funds track the S&P 500, which includes 500 of the top companies in leading industries of the U.S. economy. Other common benchmarks include the Russell 2000, Dow Jones Industrial Average (DJIA), Nasdaq 100, MSCI EAFE Index, and the Wilshire 5000 Total Market Index.
How much of my income should I invest in index funds? ›
Some experts recommend at least 15% of your income. Setting clear investment goals can help you determine if you're investing the right amount.
How long should I invest in index funds? ›
Index funds are recommended to investors with an investment horizon of 7 years or more. It has been observed that these funds experience fluctuations in the short term, but they average out over the longer term. With an investment window of at least seven years, you can expect to earn returns in the range of 10-12%.
Why doesn't everyone just invest in the S&P 500? ›
That's because your investment gives you access to the broad stock market. Meanwhile, if you only invest in S&P 500 ETFs, you won't beat the broad market. Rather, you can expect your portfolio's performance to be in line with that of the broad market. But that's not necessarily a bad thing.
How much do you need to invest in index funds? ›
For beginners, the vast array of index funds options can be overwhelming. We recommend Vanguard S&P 500 ETF (VOO) (minimum investment: $1; expense Ratio: 0.03%); Invesco QQQ ETF (QQQ) (minimum investment: NA; expense Ratio: 0.2%); and SPDR Dow Jones Industrial Average ETF Trust (DIA).
