Index funds are an extremely popular way to invest your money. But can they make you wealthy, or should you put your money elsewhere?
You can make money with index funds. Investing in index funds is a proven way to make money, with relatively low risk. There are many ways that you can make money through index funds, both passively and actively.
Read on if you want to learn what an index fund is and the 5 proven ways that it can make you money. Let’s take a look, shall we?
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Why Index Funds Are Great Investments?
An index fund is a collection of stocks and shares.
With index funds, in essence, your investment broker creates portfolio investments that mimic the performance of a targeted index. So, all you have to do is put your money in these instruments, and your broker or the financial company offering these instruments will do all the heavy lifting to generate returns consistent with the targeted index.
The broker delivers this money by splitting your money between the shares that it picked to create its index portfolio. Popular indices that are widely traded through index funds and that are favorites among passive investors include the S&P 500 and the FTSE 100.
With these funds, you invest in every company in either the S&P 500 or FTSE100.
Index funds are great investments for a few reasons.
First, they offer incredible diversification. Instead of putting your money in a single company, which could go bust, index funds give you exposure to hundreds, if not thousands of companies. So, if one company fails, another will succeed, and your overall return will even out. This reduces your investment risk considerably.
Second, the fees associated with index funds are very low. Instead of paying an actual stockbroker a considerable cut of your earnings, you’ll be paying an online stockbroker less than 1% to pick and manage your investment. Similarly, in a self managed portfolio, the amount of money and time that you will invest to achieve similar diversification is often not worth the effort for most investors.
These advantages are compounded by the fact that index funds have proven themselves at beating managed portfolios of even veteran investors over the long term.
5 Proven Ways To Grow Your Money With Index Funds
Here are 5 proven ways to grow your money with index funds:
Grow Your Money With the Value of Investments
Over time, the value of your index fund is, most likely, going to increase. This is because as companies generate more revenue, their share price increases, but the number of shares you own stays the same.
Let’s use an example. Say you bought 100 shares of ‘Company X’ for $ per share in 2,000. However, the company became more successful over time, and now the shares are worth $30. This is known as capital gains, and it’s the most prominent way to earn money through index funds.
You can expect your money to increase by around 8% per year, on average, over a very long period. This figure generally beats the markets, and the fees involved with index funds are so low that they won’t cut into your profits.
This method of making money is only for the long term, though. This is because your value of the investment can go down dramatically in times of economic depression. As such, you’ll need to hold your investment for around 30 years to combat any price decreases.
Ultimately, the increase in value of your investments is the primary way to make money from index funds.
Let Your Money Grow With Compounding
Compounding is the catalyst for the long-term investor. It can quite literally make you rich beyond your imagination.
Compounding is when the money you invest in increases, meaning you have more money invested, and the cycle continues — exponentially.
Compounding can make your rates of return double what they would’ve been otherwise. But to benefit from compounding, you need to have time on your side.
For example, if you invested $10,000 over 25 years at an average return rate of 8%, you’d have around $73,000, which is not bad at all. However, if you invested the same amount for 45 years, you’d have $361,000.
Compounding certainly can make your investment portfolio rise beyond your belief. The best way to benefit from it is to invest as early as possible. This will allow your money to grow by itself over a long period.
Retain the Value of Your Money by Combating Inflation
When you put money into a bank, sitting there is losing value — typically around 2% per year.
So, if you had $1,000 in the bank in 2015, it would only be worth $900 in 2020 (at a 2% annual interest rate).
This is a scary prospect, and it seems like you can’t do much about this dwindling value of money. But index funds can help you to combat inflation.
You can think of index funds as a long-term savings account. You put your spare money in, and when you retire, you collect your rewards. But instead of losing money, you’ve gained it at 8% per year.
Of course, investing in index funds is much riskier than putting your money into a bank. However, history has shown that long-term index fund investors have never lost money. Furthermore, you should only invest what you can afford to lose.
Overall, if you don’t like the thought of your hard-earned money losing value, then investing in index funds could be a great way to go.
Take Advantage of Dividend Payments
Companies that earn a lot of money often pay out dividends to their shareholders. It’s almost like a little thank you for investing and believing in them.
Dividend payments are often around 1-3% yearly. This doesn’t sound like much if you’ve only got $50 invested. However, if you have $500,000 invested, then every year, from doing nothing, you’ll receive around $15,000 in dividend payments.
Index funds often pay dividends. Current rates are generally just below 2%. Again, this might not sound like much, but over time, your investment portfolio will grow, along with your dividend payments.
Many investors don’t withdraw the money they receive from dividends. Instead, they’ll reinvest those dividends back into the company. This accelerates the effects of compound interest and will help increase your portfolio’s value over time.
Dividends aren’t a short-term way of making money. It’ll take multiple years to receive a substantial amount of dividend payments. However, once you’ve built your portfolio, the money you receive from dividends is entirely passive — you don’t have to do a thing.
Save by Avoiding Tax
There are legal ways to prevent the government from taking a cut off your hard-earned investment portfolio.
If you’re in the USA, you can put your money into a 401(k). This stops your capital gains from being taxed, which means that all the capital gains you make will enjoy the power of compounding, until you decide to withdraw it.
If you’re in the UK, you can place your money into an ISA. This is entirely tax-free, so all of the money that you make is yours to keep.
If you don’t put your money into one of these accounts, expect up to 40% tax deductions on your short-term returns! Such aggressive taxation can seriously affect your portfolio, so it’s a great idea to get your money into one of these accounts.
The best thing about this is it’s completely legal so that you won’t be getting into any trouble with the government. You might annoy friends and family who pay tax on everything, though!
So, there are 5 ways that index funds can make you money.
Primarily, your money will be made through capital gains. Second, compounding and dividend reinvestments will accelerate this, leading to yet more capital gains. Third, the rate of return will mean that you’re increasing your wealth and not letting it succumb to inflation over time. And finally, putting your money into a tax-free account will mean that all the money is yours to keep!
Something to keep in mind, however, is that although diversified, index funds still carry risks. Despite past success, you could end up losing all of your money in index funds. As such, you should only invest what you can afford to lose.
It’s also a great idea to get to know your investments and the markets, as then you’ll have a greater understanding of just what your money is doing.
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Overall, index funds are an excellent way to grow your money. By investing your money, you can avoid both inflation and tax while simultaneously compounding your capital and receiving dividends.
Always be aware that your capital is at risk when you invest, so only invest what you can afford to lose.
BEFORE YOU GO: Don’t forget to check out my latest article – ‘Exploring Social Trading: Community, Profit, and Collaboration’. I surveyed 1500+ traders to identify the impact social trading can have on your trading performance, and shared all my findings in this article. No matter where you are in your trading journey today, I am confident that you will find this article helpful!
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