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As you might already know, there are many tools one can use to track the stock market’s performance, the most popular one being stock indexes.
How a stock index works is not too complicated. After selecting a specific stock or group of stocks, a stock index collects numerical data based on their respective performance over a determined period.
But what if we told you that stock indexes aren’t strictly limited as a pre-investment research tool? There’s also the option of using them for index funds.
An index fund is a type of investment usually managed by professional financial firms. They continuously track a predetermined stock index, make an investment to every component included in it, and then modify them over time to mimic the index.
The idea behind investing in index funds is that, as you imitate a specific profile, your investments will match that same performance just as it is taking place in time. Take note: they’re not attempting to surpass its performance, just imitate it.
How to start investing in index funds
Your first step is to pick an index out of the hundreds of available options for tracking. Depending on what your interests are, you could be choosing an index out of the following categories:
- Indexes that track large U.S. stocks (i,e. S&P 500).
- Indexes that track small U.S. stocks (i.e. S&P SmallCap 600).
- Indexes that track international stocks.
- Indexes that track specific industries.
- Indexes that track new but fast-growing companies.
The list is not limited to the ones above, but those are the most common ones. You can find more through researching indexes online.
Your second step should be finding a fund that tracks that particular index you already chose. You should know, however, that funds are not limited to just one per index, so you will be finding dozens of funds that are tied to the index of your preference.
To make sure you go for the best index fund out of all your possibilities, you should be asking some simple questions:
- Which fund tracks your index the closest?
- Which index charges the lowest costs?
- Do any of the funds have any restrictions regarding your investment in them?
- Are there any other funds offered by the same provider that could also be useful to you?
Answering those questions should make the process of choosing way easier.
Finally, you should now be ready to buy an index fund share. As with any other type of investment, you can open a brokerage account that allows you to participate in trading shares and then make a deal with the index fund provider. Alternatively, many index fund providers also offer the opportunity to open an account directly with them.
Remember, be sure to make fair use of the information you got with your research. Compare the answers to the questions above to your interests and expectations for your investments. Those are your best tools to determine the path you’ll follow when investing in index funds.
Pros and cons of investing in index funds
Out of all the types of investments in the market, index funds represent probably the most comfortable and straightforward method for any investor to build wealth. Matching any investment to a thriving market’s ever-growing performance is a great way to make a profit in the long run.
Among many of its benefits, you can also find:
- A lesser amount of time spent researching individual stocks.
- Lesser risks when investing.
- A great variety of businesses to invest in.
- Low costs (that includes tax costs as well).
- Easier to keep that investment in the long run without having to sell.
However, keep in mind that investing in index funds also means sacrificing certain aspects of stock investing that could be within your interests to keep. Depending on what you want, of course.
- You’ll never have a chance to outperform your market, as you’ll be in constant pursuit of matching their performance. If you want to grow independently as an investor, this is not the place to do so.
- In the case you were to face losses in your investment, there is no protection against it. Keep in mind that if your market faces a downhill, your investment will very likely mimic that downhill as well.
- You only get to choose an index of your liking, but that index could very well still have on it specific shares that you’d rather not own, or you could even miss out on some individual stocks that you’d like to acknowledge that aren’t included in the index.
If you are interested in balancing the pros and cons of index funds, a great solution to the problem would always be to own shares in both index funds and independent investments at the same time. Instead, if you are still interested in owning shares exclusively via index funds, be aware that you’ll have to be accepting of their disadvantages in the long run.
Four index funds you can begin with
Here are four indexes you can take a look at and start with. These are from the Vanguard Group, the most popular group due to their performance and reputation as an easy starting point for new investors.
- If you are interested in tracking S&P 500, try Vanguard 500 Index.
- If you are more interested in tracking U.S. stocks of all sizes, try Vanguard Total Stock Market.
- If you are looking for global stocks, Vanguard Total International Stock Market is more your speed.
- And finally, if you’d prefer to deal with bonds, try Vanguard Total Bond.
Index funds offer everyone a reliable and straightforward way to invest. If you want to make your money work for you but research isn’t your thing, investing in index funds is one of the best options for you.