There seems to be a lot more talk about the importance of investing in Index Funds recently, and for good reason. Index Funds, as a product class, gives investors from all walks of life a trouble-free means to invest something into many stocks all at once. They are a type of mutual fund that tracks all major indices and have lower management fees than those which contain a much smaller basket of stocks which require much more manager involvement. Some common indexes are the S&P 500, Russell 2000, and Russell 1000.
Now, when I think about the idea of investing money in hundreds of stocks at once my initial reaction is, “Yikes, I can think of a lot of companies that I wouldn’t like to buy into!” That is, unfortunately, an assumed risk you take. There is no way to predict what company may disappoint you (again) or make decisions which are against your political, social or even financial ftinterests if you happened to be a customer. People’s reasoning for preferring one company over another are innumerous. And contrary to popular opinion, it may have little to do with how successful their earnings record is. Some people want to specifically invest by industry: biotech, clean energy, or pharmaceutical research, for example. Index funds are advantageous because whether you just started your retirement planning, or you have been saving for 25 years, you can trust that you are making sound judgement as an equity investor.
As in any securities product, there is a downside to investing in index funds. Suppose a couple of companies’ stock in a market sector is performing extraordinarily well, quarter after quarter. Management is stable and performance ratios are all in the green zone. Other stock prices in the same sector tend to creep up, too, as the industry leader value moves further out of the reach of would be buyers. A group of stocks can end up having artificially inflated prices when only one or two reflect their true market value. There is no way to deleverage the affect that underperforming stocks are having on your index owned to mitigate a potential loss when that market drops. Whereas, in an actively managed mutual fund, researchers are working to identify who is performing to tactically rebalance stock holdings and maintain ideal returns for a fund.
Earlier I mentioned how much influence personal preference alone can affect people’s investment decisions. This is where index funds get a little more interesting… Are you interested in investing in developing nations? There are foreign index funds for emerging market regions of the globe. Maybe you hate taxes, and would do anything just to keep from paying a few bucks of capital gains tax of any kind, ever? Try a tax-loss reducing index fund. Index funds also settle more quickly when you need to sell, and you won’t pay a commission on your trades. Just be ready for the bear markets, which come and go, and you will do fine in your long-term investments in market composite index funds.