A lot of people would have loved to have hit it rich by investing in companies like Amazon, Apple, Netflix, or Google when these companies were in their infancy stages. The stock market is appealing to investors because of the promise of big returns. The truth is buying stock in individual companies can be really risky. For every Apple which has made early investors rich; there is a GoPro Inc. which has crashed from the $80 dollar price range to $6 a share. While I love buying individual common stocks; finding quality long-term growth stocks is not easy. I have to evaluate the fundamentals, review financial statements, pay attention to quarterly earnings and be prepared to take on substantial risk. I always have to be aware of what is happening with the companies I am investing in. If this sounds like too much of a hassle for you; there is an easier way to invest in the market without having to track individual companies. Index funds are the easiest way to invest for most investors.
Index Funds Are An Easier Way
The answer is by buying an index fund. Index funds are the best friend of the passive investor who want an easy way to invest in the market. An index fund is a type of fund with a portfolio constructed to track a certain index. Index funds can track the return of the S&P 500, Dow Jones, or NASDAQ. Index funds can either be exchange traded funds or mutual funds that hold securities in a given market. A S&P 500 index fund will buy shares of the 500 largest companies in the United States and will track the movements of the Standard and Poor’s 500 index. This fund will replicate the performance of the S&P 500 index. If the S&P 500 index is up 10 percent for the year then a fund like the Vanguard S&P 500 index or the iShares S&P 500 index should be up approximately 10 percent as well.
Advantages of Index Funds
Broad Diversification
An index fund provides an easy way for an investor to own hundreds of stocks without having to buy individual shares in each. It’s a much cheaper way to create a truly diversified portfolio which helps to reduce the risk of just owning one or two companies. A S&P 500 index fund provides diversification amongst a number of sectors allowing you to get financial, energy, retail, tech, healthcare, and consumer staples exposure in one fund.
Lower Fees
You want to know how to become a millionaire? Avoid unnecessary fees! Unlike actively managed funds, index funds have much lower expense ratios with many funds well below 1 percent in expense fees. Index funds do not require a fund manager to trade in and out of positions based on performance. The only rebalancing for an index fund is when a company enters or exits the index.
Lower Taxes
Actively managed funds have far greater portfolio turnover. The fact that index funds have much less portfolio turnover means less short term capital gains and capital losses.
Lower Capital Requirements
It could take $10,000 to build a well-diversified portfolio. An index fund just requires buying one share of a fund to receive this type of diversification. Take the Schwab S&P 500 (SWPPX) index fund for example. One share of this fund currently costs just under $45 per share. So for just $45 a share, you own Microsoft, Apple, Amazon, Berkshire Hathaway, Facebook, Johnson & Johnson, JPMorgan Chase, Alphabet, and Exxon Mobil.
The primary disadvantage of an index fund is that you will not receive the same upside profit potential as you would in owning an individual company. While your downside risk is reduced, your upside profit potential is reduced as well since one company will not have a tremendous impact on your portfolio.In my opinion, a S&P 500 index fund is a must have for every investor seeking simple worry free exposure to the stock market. Famed investor Warren Buffett believes that buying an index fund makes the most sense for most investors since index funds outperform most managed portfolios and often beats trying to construct your old portfolio.
