Index funds are investment assets, in ETF or mutual fund form, that track the performance of a specific financial index, such as the S&P 500 or the Nasdaq. They’re considered passive investments, as opposed to active ones, in that their price movements simply mirror an index and that they aren’t strategically directed by a professional asset manager picking stocks. So, is it a good idea for beginner investors to choose index funds?
Index funds are a great type of investment for beginners because they are simple and effective. They represent an efficient way of netting average market returns in your investment portfolio without significant time or energy spent doing research. They’re also relatively less risky.
It’s for this primary reason, and a few others, that index funds have become so popular in the modern investing world. Read on to learn more about index funds and why they are good for beginners.
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What Are Index Funds?
Index funds are associated with financial indexes, so first and foremost, it’s essential to understand what an ‘index’ is.
According to Investopedia, an index “measures the price performance of a group of securities using a standardized metric and methodology.” Some of the most popular and widely known indexes include the Dow Jones Industrial Average, the S&P 500, the Nasdaq, and the Russell 2000.
Each index provides an efficient way of understanding how a given sector of the financial market is doing by simultaneously tracking the price performance of all the major companies that drive it. Of the many indexes out there, each provides a distinctive, more or less wide-ranging view of the financial markets as a whole.
An index fund allows a retail investor to capture a given sector of the market associated with an index. Index funds attach their price to the day-to-day fluctuations of the index that they track and thus provide an investor with that same performance over time.
Index funds follow their benchmark index regardless of the rest of the markets. For example, during the month of July 2021, the S&P 500 index value moved from 4,320 to 4,395, an increase of 1.73%. During the same period, “SPY,” the S&P 500 ETF, had its share price move from $429 to $437, an increase of 1.86%. The .13% difference between the actual index value versus the ETF is likely due to the ETF’s tracking error or other minor structural differences.
To see how closely any given ETF tracks their designated index, you can perform the same comparison as the above example, using Yahoo Finance or other financial websites’ historical price pages.
By comparing index values over a certain period versus the ETF or mutual fund’s per share price for the same period, you can see how closely your chosen fund tracks its benchmark.
The website ETF.com even provides a nifty comparison section for each ETF’s info page that you can access for free.
In all, index funds give investors broad market exposure, low operating expenses from their providers (such as popular financial institutions Vanguard, Fidelity, or SPDR), and low portfolio turnover.
Now that we have covered the fundamentals here, let us dive deep into the crux of our discussion here – What makes index funds so good for beginners?
Why Are Index Funds Good for Beginners?
A simple google search will get you a long list of reasons why index fund investing is ideal for beginners. But, I firmly believe in the downside of something called Too Much Information.
Therefore, in this section, let me isolate for you the most common advantages and disadvantages of index fund investing that you will find on the internet. In the following section, I will share with you my personal perspective on the same.
Most prominently, popular finance websites list out the following as the major pros and cons of the index fund:
- Dependable performance
- Lower costs
- Lack of flexibility
- Tracking error
- Management differences
Why Should You Invest in Index Funds as a Beginner?
Perhaps the top advantage that index funds provide is diversification. Financial indexes include hundreds and sometimes thousands of companies, so they’re heavily diversified.
Therefore, index funds are automatically risk-managed assets to invest with given they track such diversified indexes. And all good investors know that diversification in equity investing is absolutely necessary.
Their pre-diversification alone makes index funds a very attractive investment option for beginner investors who may not have (or have the inclination to learn) the necessary knowledge to build their own diversified portfolio of stocks.
Index funds also feature some of the lowest costs in the finance world, since they’re passive investments and don’t require a high management fee to run.
ETFs and mutual funds include a cost to the investor in the form of an expense ratio. This minor cost cuts into the percentage return of a fund and goes to the financial institution charged with creating, selling, and managing these investment assets. For index funds, simply, these expense ratios are at their lowest.
Finally, the index fund’s clear transparency and dependable performance provide the novice investor with an understandable way of seeing:
- How their asset’s underlying portfolio is structured
- How it grows over time.
How company stocks (or bonds) make their way into a major financial index includes a clear and reasonable process for investors to see. In short: the biggest (by market capitalization), most productive, and/or most important companies make up the popular indices of the world. Indexes are a measure of the economy, so their entrants are likely to be legitimate and growing businesses.
Given ordinary conditions and even through the global financial system’s boom and bust cycle, the overall stock market’s growth is practically assured over the long term (of 30+ years).
Thus, index funds provide a beginning investor with all the critical factors within the investing realm:
- Low cost
The disadvantages of index funds are likely to be a problem primarily for more educated investors.
Lack of flexibility in the underlying holdings and lack of expert managerial oversight are what mark index funds as “passive” investment vehicles. It isn’t easy to modify their performance because they’re tied to the underlying benchmark, and their holdings can’t be customized by expert managers.
They don’t have active human managers at all but instead have benchmarks they adhere to in the form of their index.
For beginner investors, who may not know much or have a desire to learn more about the finance world, these are hardly problems at all.
In fact, for much of recent history, an index fund has been likely to outperform the more complicated and costly actively managed funds out there anyway!
How To Choose Your Beginner Index Fund?
Even as a beginner investor choosing one of the most simple and reliable investment assets (the index fund), you’ll still need to develop a defined investment goal.
The big questions: What are you investing for? For how long? (For index funds, it should definitely be for the long term!) What is your risk tolerance?
Some smaller, more discrete questions: What’s the expense ratio of your index fund? What’s its fit to its designated benchmark? What’s its beta (or relative risk to the overall market)?
Most expense ratios and benchmark fits for any given ETF will be comparable, thus making it challenging to differentiate funds on those factors alone. Beta can provide such a differentiating factor, however.
For beta, consider that the large cap-oriented S&P 500 index basically captures the overall stock market’s movements, and thus SPY has a beta value of 1.0. Any other index fund’s beta reflects how much more or less risky it is compared to the overall market or SPY.
For example, the Russell 2000’s IWM ETF’s beta of 1.27 means that the small market-tracking index fund is about 27% more volatile than the overall market. Alternatively, the short-term bond market ETF, BSV, has a beta of 0.35. This means it’s about 1/3rd as volatile as the broad equity market.
In this way, beta is an excellent metric for beginning investors to use to gauge the relative risk rating of an index fund.
ETF.com, Yahoo Finance, Google Finance, and Morningstar all provide great search engines to evaluate and compare the different metrics of index funds against one another.
However, for most beginning investors, the best bet is perhaps to just “buy the market.” Warren Buffett, one of the greatest investors in history, recommends that retail investors simply buy into an S&P 500 index fund (as good of a proxy for “the market” as there is) over time and move on with their lives with their investment portfolio secured as such.
The overall stock market return averages about 8-10% per year in modern history and is the general benchmark gauge that all investments are compared against.
And if you can’t beat it – as many professional investors do not! – why not just join it?
For additional info on index funds and how to choose them, Bankrate, Nerd Wallet, and TIME each provide their own relevant online guides on the subject as well.
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All in all, index funds are perhaps the very best style of investment for beginners. They provide reliable performance, risk-managed via their automatic diversification, and all at a low cost from dozens of reputable major financial institutions.
For the beginner investor, index funds provide a steady return that may end up outperforming most other, more involved strategies anyway!
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