Investing With Index Funds
If you are familiar with the investing world, you are probably also familiar with the importance of diversification in a portfolio, and index funds are a great step towards accomplishing this.
*A quick refresher, diversification is key to building wealth because it limits your risk by offsetting the volatility of your portfolio with a healthy balance of securities. Now lets get back into the good stuff…
Index funds are ETFs or Mutual Funds that are constructed to track a market index. This might sound unnecessarily complicated, so let’s break it down.
ETFs and Mutual Funds differ in how they are traded and managed, but they are essentially both baskets of different kinds of investment holdings (stocks, bonds, etc.). Though their profitability can vary depending on the fund and the state of the market, index funds are generally a great addition to a portfolio. But how do they help to diversify a portfolio? Index funds try to match the market based on the belief that the market will outperform other single investments, which makes them a powerful investment in the long term. Note that we are talking about passively-managed index funds (because actively-managed index funds typically seek to outperform the market).
“By periodically investing in an index fund, for example, the know-nothing investor can actually outperform most investment professionals. ”
Now that we have covered ETF’s and mutual funds, lets talk about the market index that they are designed to track. A market index is a hypothetical portfolio of holdings that represents a sector of the market. It is formed by using each company’s market capitalization to figure out how much weight the holding will have within the index. This market cap is the total value of a company’s shares, and is calculated by multiplying share price by the quantity of outstanding shares. Alternatively, some market indexes use price per share or derivatives to determine the weighting of different securities. For example, The S&P 500 Index is a market capitalization weighted index. It represents 500 publicly traded companies in the U.S, and though you cannot invest directly into it, you can invest in any one of the numerous index funds that use it as a benchmark.
We hope this helps, and feel free to drop a question/comment or article suggestion down below!