What are index funds?

30 Jul 2021

Index funds and ETFs

You might have heard of the S&P 500, Nasdaq, or Dow Jones Industrial Average. These are called index funds. The S&P 500 index represents the top 500 publicly traded companies. There are some special criteria for a company to achieve before being allowed access to this elite club but to keep this simple you can think of these as the companies with the largest market capitalization (total dollar market value). Index funds are a great way to quickly review the current market sentiment and see trends over the long term. However, indexes cannot be directly invested into but there is still a way to take advantage of these extremely powerful market tools. There are dozens of ETFs (Exchange Traded Funds) and Mutual Funds that closely track each of the index funds out there. So you can purchase one share of an ETF that tracks the S&P 500 and instantly be a partial owner of the 500 best companies! How cool is that?!

Buying into an index fund through an ETF or mutual fund is a great way to diversify to protect yourself from downturns from any one sector. If there are trade tensions in the middle east and the energy sector gets crushed, you will not feel the full brunt of that dip like you would if you owned Exxon Mobile. Another great benefit to owning an index is that, on average, the S&P 500 has given returns of 10% per year! Again, this is an average so some years they can be up 30% while other years they might tumble 40%, but over the long term these wild swings average out to about 10%.

What are the other index funds? The Nasdaq is comprised of about 3,000 companies, most notably the tech giants Apple, Google, Microsoft, Oracle, Amazon, and Intel. The Dow Jones Industrial Average is made up of 30 companies, these companies are some of the biggest household names you can think of (Walmart, McDonald's, Nike, Disney, etc). Had enough of the mega-companies? Maybe you will be interested in some up-and-coming companies. The Russell 2000 holds the top 2000 small capitalization (between $300 Million and $2 Billion).

Buy the collection or individual company?

Tired of all of these decisions and just want to invest without all of the hassle? Buying an index fund allows you to simultaneously buy dozens or hundreds of companies with a single purchase. The risk from individual companies will be spread out over the whole lot but the potential gains will be flattened as well. Historically, the average return of the S&P 500 is about 10%. This usually beats inflation while offering lower risk and less research commitment than picking individual stocks.

Buying individual companies is riskier but the increased risk does bring the potential for much greater returns! Some skilled investors can consistently beat index funds of their returns by finding successful high-growth companies before everyone else, buying value companies when they are cheap, and reinvesting dividends when a company issues them. If you enjoy taking the time and effort learning about companies and industries while managing risk, buying individual companies might be appealing to you!

Of course, you do not have to pick one or the other. Based on your investment goals you can tailor your portfolio accordingly. Maybe you are 18 and can afford to risk some extra money for potential large short-term gains. In this case, allocating 80% of your account to individual investments and the other 20% to index funds might be a strategy to consider. Reevaluating the percent allocation every quarter will automatically balance your account! For example, when you reevaluate and your individual investments did very well the percent might have shifted to 85% individual investments and 15% index funds. Buying index funds with the profits from the riskier individual investments lock in those gains!