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 aims to generate returns from the broader market by tracking an index. ThatS&P500is the most popular index to track, with a historic annual return of 10%.
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- Index investing is a passive investment method achieved by investing in an index fund.
- The advantages of index investing include low costs, requiring little financial knowledge, convenience and providing diversification.
- Disadvantages include the lack of downside protection, no choice in the composition of the index, and the index (by definition) cannot beat the market.
- To index, you need to find an index, find a fund that tracks that index, and then find a broker to buy shares of 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 involves frequent buying and selling, combined with continuous monitoring of performance.
Exchange traded funds (ETFs)is the preferred security for index investing. That's because ETFs are passively managed and therefore cheap: the perfect medium for an index fund.
Benefits of index investing
Warren Buffet once said, "A low-cost index fund is the wisest stock investment for the vast majority of investors," and it's easy to see why.
- Discount: Because index funds take a passive approach to tracking an index, there are lower management fees associated with an actively managed fund
- Requires some financial knowledge: Index investing is relatively simple compared to building your own portfolio
- Ease: Index funds contain hundreds of stocks that are incredibly difficult to replicate on an individual level
- Diversification: Holding a large selection of stocks diversifiesidiosyncratic (company specific) risk
Disadvantages of index investing
- Lack of downside protection: There is no floor for loss
- No choice in the composition of the index fund: Cannot add or remove holdings
- Can't beat the market: Can only achieve market returns (in general)
How to get started with index investing
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The first step in index investing is choosing the right index for your preferences. As mentioned, a commonly used index to track is the S&P 500, an index composed of 500 large American companies. Other popular indices include the Dow Jones Industrial Average (DJIA), a composite of 30 major U.S. companies, andNASDAQ Composite, another US-based index heavily weighted in the IT sector. The US market is often used synonymously with the broader market due to its importance and influence as a financial center.
For those with more advanced financial knowledge, index investing can be a very useful tool for potentially 'beating the market'. If you expect a particular region, sector or factor to outperform, you may choose to invest in an index that specializes in such areas. For example, if you expect Asia to do better in the future, you might consider tracking an Asian index. Popular indexes include:
- Shanghai SE composite index (Kina)
- Hang Seng-index (Hong Kong)
- Nikkei 225(Japan)
The stock market consists of 11 sectors, formally known as the Global Industry Classification Standard (GICS). Such sectors include IT, healthcare, consumer goods, energy, industrials and more. There are many sector indices available that can be benchmarked.
Finally, a factor is an attribute that has historically been proven to produce excessive returns for all assets. Some identified factors include:
- Value
- Maat
- Quality
- Momentum
- Volatility
- Growth
Each factor performs well at different points in the business cycle. If you have confidence in a particular factor, you can focus on it by purchasing a factor index.
Of course, it should be noted that investing in a particular area will increase your risk. The reason for this is that if you choose to be overweight in a particular region/sector/factor and it ends up underperforming, all your investments will suffer. Nevertheless, higher risk comes with higher returns, so if you bet on a specific area that is performing positively, you can beat the broad market.
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The second step is to choose a fund that tracks such an index. There are many ETF providers offering similar offerings with minor variations, so it's wise to research the differences. Such differences could include expense ratio, dividend yield, performance, and more.
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The final step is to buy shares of your chosen index fund. For this you must open an account through a broker. Again, each broker can offer different pros and cons, so it's important to compare before jumping in.
More resources
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