Index Investing Basics

“Indexing” is a low cost, accessible way for investors to participate in the global markets – for beginners and experts alike. By taking advantage of broad market index funds, individuals can almost instantly create diversified portfolios representing various asset classes, regions of the world, and sectors/industries. But amidst the excitement, the basics often get lost. Today, I’d like to rewind and cover some essentials of index investing.

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What is an index?

An index is a representative collection of investments. For example, if you wanted to monitor the aggregate behavior of the biggest 500 company stocks in the US, you’d look at the S&P 500 Index. Other indexes track different sized companies, countries or regions, or asset classes (like bonds or commodities). Investors look to the various indexes as proxies (either on their own or blended together) for the stock or bond markets as a whole.

What is a fund?

The word “fund” usually refers to a mutual fund or exchange traded fund (ETF). There are many similarities between the two, and some key differences – but we’ll cover that in another post. Bottom line – a fund is a basket of holdings that investors can buy. Inside the basket are scores (or hundreds) of individual holdings. So, when purchasing a fund, and investor can immediately own numerous companies all at once. One holding, instant diversification.

Active vs. Passive

Funds come in all shapes and sizes. Some are actively managed to attempt out-performance of the markets – I’ll refer to these as “active funds”. Others simply represent specific indexes, and attempt only to track the movements of those indexes as closely as possible. These, collectively, are called index funds.

What’s so “Low-Cost” about it?

Index funds carry lower expense ratios than active funds (in general). We’ll cover expense ratios in another post – but to put it simply, it’s the fee paid by investors for the upkeep & management of the fund. An active fund is more expensive to run (analysts, trading costs, research) and can have an expense ratio in the 1% range, give or take.

An index fund is intrinsically cheaper; because the fund simply tracks an index, the overhead cost is lower. Some of the cheapest index funds have expense ratios under 0.10%. That’s a big difference – especially when looking at the growth of an investment over multiple decades.

Put it together, and…

Index Investing is the leveraging of index funds to participate in the markets. Rather than trying to beat the market, index investors often simply hope to take a representative share of the long term growth of capital markets.

Simple, right?

Index investing can be very simple. But, it doesn’t take long to get very nuanced. If you decide to be an index investor, you’ll face a whole array of decisions, including:

  • Selecting an asset allocation (stocks, bonds, cash, alternatives)
  • When & how to re-balance your account
  • Selecting a custodian & fund family
  • Identifying & purchasing appropriate funds
  • Establishing a disciplined contribution & trading strategy

Luckily, in today’s world, investors are spoiled for choice when it comes to getting help. From DIY to robo-advisor, from robo-hybrid to professional management, there’s way to find help for all levels of expertise, interest, time, and budget.

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