Trying to figure out which types of investments to include in your portfolio can be tricky. After all, there are so many options to choose from and it can feel overwhelming at times—and most people feel like giving up before they get started.
But the fact that you’re here reading this tells me that you, my friend, are not like most people. You want to take charge of your financial future, and that starts with getting familiar with all of your investment options—including index funds.
Index funds get a lot of talk on the cable news shows and all over message boards, but are they really the best option when it comes to investing for retirement? Well, I’m here to break down index funds for you so that you can decide whether or not they have a place in your investment plan.
Ready? Let’s do this!
What is an index fund?
An index fund is a type of mutual fund designed to mirror the performance of the stock market or a particular area of the stock market.
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A mutual fund lets investors pool their money together to invest in something. So in this case, the money in an index fund is used to invest in stocks, bonds or other types of investments inside a particular index. Speaking of which . . .
How do index funds work?
In order to understand how an index fund works, it’s important to understand what an “index” is. When it comes to the stock market, an index is basically a measuring stick. Indexes help investors measure the performance of the stock market in almost the same way you would use a ruler to measure how long something is.
There are hundreds of different indexes out there to measure many of the different sectors of the stock market. The S&P 500 Index, for example, is the one most experts use as a benchmark for the overall U.S. stock market. Standard & Poor (S&P) is a ratings agency that identifies the top 500 largest companies on the New York Stock Exchange to include in its index. In a very real way, they use it to measure the overall performance of the stock market.
So, what’s inside of an index fund? It depends on the index the fund is based on! An S&P 500 index fund, for example, is made up of stocks from many of the companies found inside the S&P 500 with the goal of mirroring the performance of that index. So, if you invested in an S&P 500 index fund, you own 500 stocks in a single fund with returns that are almost identical to the gains (or losses) of the S&P 500 itself.
This makes index funds a very “passive” form of investing. Instead of being run by a fund manager looking for investments that will beat the market, an index fund is more than happy to settle for “average.” Index funds are like mirrors—they’re designed to copy the performance of the index they are based on. No better and no worse!
What are some different types of index funds?
From bonds to foreign stocks and everything in between, there are hundreds of indexes out there used to track the performance of almost every sector of the financial market you can think of. And if there’s an index for it, you can almost bet your bottom dollar there’s an index fund for it.
We’ve already talked about the S&P 500 index fund, which is probably the most famous example of an index fund out there. But that’s just the tip of the iceberg! Here are some other common index funds you’ll find, and you’ll notice that each one has its own unique flavor:
- Russell 2000 Index Fund: This fund is made up of stocks that are in the Russell 2000 index, which focuses on smaller companies.
- Wilshire 5000 Total Market Index Fund: Made up of almost 3,500 stocks, this is the largest U.S. stocks index out there and is also used to measure the performance of America’s publicly traded companies.
- MSCI EAFE Index Fund: Whoa, that’s almost half the alphabet right there! All you need to know is this index fund mirrors the performance of the international stock market, with foreign stocks from Europe, Australasia, and the Far East (that’s what “EAFE” stands for) included in the mix.
- Barclays Capital U.S. Aggregate Bond Index Fund: This index fund is very different from the others in this list. That’s because this index follows the performance of the U.S. bond market and is full of bonds instead of stocks. Bonds are basically loans where the government borrows money from investors—and agrees to pay them back, with interest.
- Nasdaq Composite Index Fund: This fund has stocks from around 3,000 companies listed on the Nasdaq exchange, which is often used to measure the performance of the technology sector.
- Dow Jones Industrial Average (DJIA) Index Fund: The Dow Jones is the oldest stock market index in the U.S., made up of stocks from 30 large companies from all kinds of different industries. This index fund will have stocks from companies that are included in the Dow Jones index.
Remember, with an index fund, don’t expect to get returns that are better or worse than the stock market or the index the fund is mirroring. Basically, you are the market.
What are the advantages and disadvantages of index funds?
If there’s one thing I tell everyone about investing, it’s this: Never invest in something you don’t understand. You need to have a good grasp of your investing options before deciding to invest your hard-earned money into anything. And that means weighing the pros and cons of all your options—including index funds.
Here are some of the pros of having index funds in your investment portfolio:
- Index funds are diversified. Like I mentioned earlier, index funds are a type of mutual fund. And like other mutual funds, index funds are usually filled with stocks from hundreds of different companies. That gives you a nice layer of diversity.
- Index funds have lower expense ratios. Because index funds are basically just copying the index they’re named after, there’s not much to manage. Because of that, index funds usually have lower fees and expense ratios.
- Index funds are predictable. What you see is what you get. With an index fund, you know you’re going to get returns that are more or less the same as the stock market. And just like the stock market, there are going to be ups and downs.
But here are some reasons you might want to think twice before adding index funds to your investment mix:
- Index funds won’t beat the market. Listen, average is okay. But do you want to settle for “okay”? I don’t think so!
- Index funds are not very flexible. What’s inside of an index fund isn’t really up for debate. It only changes if the index it’s based on changes. So, the holdings inside your S&P 500 index fund, for example, will only change if the S&P 500 drops some companies for others in its index.
- Some index funds have higher maintenance fees. You’ll hear a lot of about lower expense ratios from index fund crusaders. But hold up! While it’s true that many index funds have lower expense ratios than actively managed mutual funds, they’ll charge a hefty maintenance fee—sometimes listed as a “12b-1” fee—to make up for it. And those can really hurt your returns in the long run. Be on the lookout for those!
Should index funds be part of your investment strategy?
Listen to me, I don’t want you to settle for average. Here’s my advice: Invest 15% of your gross income in good growth stock mutual funds that have a long track record of strong returns that beat stock market indexes like the S&P 500.
Your investment portfolio should be divided evenly between four types of mutual funds:
- Growth and income funds: These are the most predictable funds in terms of their market performance.
- Growth funds: These are fairly stable funds in growing companies. Risk and reward are moderate.
- Aggressive growth funds: These are the wild-child funds. You’re never sure what they’re going to do, which makes them high-risk, high-return funds.
- International funds: These are funds from companies around the world and outside your home country.
That way, your investment portfolio will be well diversified—which means you’re not keeping your entire nest egg in one basket. But you’re still going after funds that are going to beat the market and help you build a nice, big nest egg for retirement over time.
Get With a SmartVestor Pro!
Now look, some mutual funds underperform the stock market—and you want to stay far away from those—but there are many mutual funds out there that outperform the market. Picking and choosing the right funds is a big deal, people! That’s why I always want an investment professional in my corner to help me separate the winners from the losers.
And besides, it’s always a good idea to sit down with a pro who can help you set goals for your financial future and help you understand all your options, from index funds to growth stock mutual funds.
Our SmartVestor program is a free service that connects you with investment professionals in your area. Each one has been vetted by our team here at Ramsey Solutions, and they will patiently walk you through the investing process.