By investing in an index fund, whether it be an ETF or a mutual fund, you’re investing in a diverse mix of stocks from across the market. These pooled investments are designed to mitigate risk and provide long-term returns according to their index’s performance. But is it possible for an investor to lose everything in an index fund?
You cannot lose all your money in an index fund. Risk factors on funds always differ based on the index and the underlying assets that it tracks. But in general, index funds are unlikely to lose all or even most of their value over a period of time.
Read on to learn more about index funds, their risks, and their purpose as an investment vehicle. If you’re ready to grow your portfolio with index funds, you will need to look no further. So, without further ado, let’s get started!
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Why You Won’t Lose All Your Money Investing In an Index Fund?
The primary purpose of index funds is to provide retail investors with a basic, highly diversified, and risk-managed asset to invest in over long periods of time, such as five or more years. Per their namesake, these instruments track entire indexes of stocks such as the S&P 500 or the Nasdaq.
As a result of their diverse mix of underlying assets, it’s practically impossible for an index fund to lose all its value. While there are rarely guarantees or certainties in the financial world, an index fund going to zero is basically an impossibility.
At its core, this can be explained by two simple reasons. These are:
- The number of stocks in an index.
- Book value of companies.
Just by sheer probability, the chance of every single company’s stock price in any index simultaneously going to zero is very low. Not impossible, perhaps, but even in an overall market crash, this event is extremely unlikely.
As a result of an index fund’s diversity that often contains 100+ companies, all the stock prices going to zero is just not going to happen. Large portions of the underlying portfolio may lose significant value in a bear market or crash, however.
Furthermore, even in the event of a mass bankruptcy of every company in an index, due to the process of bankruptcy and the concept of book value, an index’s value would not go to zero. Even if a company is forced to declare bankruptcy, the book value of the assets that the company holds provides value in liquidation or reorganization.
Value remains constant for a company in debt and going out of business.
Additionally, in order for a company to qualify to be listed on popular indices like the S&P 500, they must be large and securely operating, showcasing consistent growth in book value over time. This fact makes index funds less risky, as they are pooling together investments into established companies.
The most important consideration for an investor exploring the question of risk and loss around index funds is understanding what these instruments truly are and what their key characteristics and objectives are.
Index Funds Are Low Risk, Diversified, and Long-Term Investments
Index funds are designed to be a low risk due to their diversity and the generally larger size of the companies underlying their holdings.
Additionally, as passive investment vehicles, they’re meant to be invested for the long-term, often through a dollar-cost averaging pattern. These factors are why index funds are popular selections for corporate 401k portfolios.
As a result, while an index fund is unlikely to ever lose all its value, it’s still possible for them to lose significant value in widespread market events. During the 2008 real estate crash and in 2020, in response to the uncertainties around the coronavirus, even index funds were crushed and lost significant percentages of their overall value.
It’s important, therefore, to remember the purpose of an index fund when considering your investment. They should be viewed as a pre-diversified, low risk and low cost, long-term investment in the overall market or your chosen sector.
In this case, long-term would mean to hold them for longer than five years.
Your expected gains and losses are tied to the index, of which there are many that they track. They’re unlikely to lose value in the long-term but can definitely net losses during market downturns.
Understanding these facts and preparing your investor mindset for a long-term outlook means less stress when choosing to invest in index funds.
For your index fund investment, after gaining an understanding of how they’re structured, you should do some research into the underlying index that you have chosen to invest in via its designated ETF or mutual index fund.
Despite their true reputation for being “safe,” index funds end up being as risky and as exotic as the collection of stocks that define their portfolio.
Not All Index Funds Are Created Equal
ETFs have exploded in popularity and amount over the last few decades. According to Kiplinger, there are now over 1,732 index portfolios to choose from in the form of ETFs or mutual funds.
All feature the overall advantages of index funds, such as their low expense ratios and diversified portfolios. However, each index features investments in different company sizes and sectors, which ends up varying their risk profiles.
In general, any given index fund remains a low risk and low cost relative to individual stock investing as well as most actively managed fund portfolios. But small market capitalization indexes such as The Russell 2000 feature an inherently higher beta (or risk level relative to the overall market) than large-cap indexes such as the S&P 500.
This is due to the increased relative risk of investing in small-cap stocks versus large-cap stocks, such as small-cap stocks that have higher risk and reward potential than large-cap stocks.
Alternatively, some index funds such as the ETFs SPLV and USMV specialize in investing in collections of stocks that are of lower volatility in nature versus the broad market. There are index funds for dividends, specific sectors from energy to financial to real estate, and international stocks.
Each of these index funds, while all sharing similar features, present different risk profiles. The purpose of their indices, as well as their prospective investors, is each separate and would be worth educating upon before making any purchase choices.
Delving into the realm of index funds means understanding that they’re not a monolith.
There are thousands of index funds from dozens of provider companies that each provide a different slice of the market through their portfolios. Their prospective gain and loss probabilities are each defined by separate investment criteria.
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Conclusion
Index funds won’t lose all your money. Investing in index funds is an excellent way to invest in the stock market safely, with a pre-defined portfolio that’s diverse and risk-managed. This doesn’t mean that you won’t lose money. And depending on the index you choose to invest in via an ETF or mutual fund, you may be taking on more or less relative risk than the overall market.
The most important step to index fund investing is educating yourself on how they work and the nature of whichever index you want to be invested in.
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