Are Index Funds A Good Fit For My Investing Strategy?

You have undoubtedly seen various index funds as a choice for investing in the stock market. Index funds have grown in popularity over the past 20 years.

What exactly is an index fund? An index fund is a fund that buys the companies in a particular index. An index is simply a group or “basket” of companies. Indexes have been created that are composed of groups of stocks thought to represent the overall market or certain segments of the market. Indexes also exist for almost every other type of security. One of the best aspects of index funds is the diversification they offer, however, some indexes offer more diversification than others. Let’s take a look at three common U.S. equity indexes so that next time you see them listed as an investment choice, you will feel more knowledgeable about just what your options are.

Most Common Index Funds

Probably the most common index is the Dow Jones Industrial Average (^DJI). That was the only reference made back then with regard to overall market performance. The DJIA said it all. The Dow Jones Industrial Average is an index of 30 well established companies with long histories. Formerly, the companies were more industrial related, but that is no longer a requirement for being included in “the Dow”. The companies in the DJIA do not change often. It is important to remember that the Dow represents only 30 companies; therefore, it does not represent a large group of companies. As a result, it offers less diversification than other indexes with more companies included in them.

Many newer, more broadly based indexes have come along since the Dow. The term “broad based” just means that it has more companies in its index, therefore, it represents a larger, or “broader” segment of the market. The S&P Composite Stock Price Index, also known as the S&P 500 (^GSPC), includes 500 companies thought to represent leading companies and industries in the U.S. S&P stands for Standard and Poor’s, a financial services company that dates back to 1860. Another index, the Wilshire 5000 Total Market Index (^DWCF), represents all equities headquartered in the U.S. with readily available price data. This index is intended to represent the entire U.S. stock market, and it is, therefore, very broad based.

Index Fund Advantages

With the exception of the DJIA, one of the best things about an index fund is that it holds a very large group of companies. This is good because it automatically provides diversification, and in general, diversification reduces risk. The Wilshire 5000 provides the most diversification of the three indexes above. Why is diversification so important? If you invest in an individual stock, and that company gets into trouble, then the value of your investment, and even your portfolio, could drop significantly. This under diversification frequently happens when an employee invests most of their assets in the company for whom they work.

Index Fund Disadvantages

On the other hand, if you put an equal amount of money into an index fund, and one of the companies in that fund drops in value, it will have a fairly small impact on your investment since that one company represents a very small portion of your total investment. The downside is that if a large holding has a big upward price move, then the effects of that move would be diluted in an index fund. Some actively managed mutual funds even have a disproportionate amount invested in one or two top holdings, and if one of those large holdings drops, look out. The fund will go down with it since the fund has such a large amount invested with that particular company.

There are several other advantages to investing in index funds. Index funds offer a low cost method of investing in the stock market. By this I mean that the fees are usually very low on index funds because they do not require the skills of an active manager since the fund holdings are computer generated. The fund simply buys the companies that are in the index that the fund mimics. Index funds are also tax efficient since they infrequently buy and sell securities. Additionally, not a lot of research is required to invest in an index fund since the companies in the index are already determined.

As you can see, index funds offer an excellent way to invest. It is important to note that by comparing the current values of an index with historical values, an investor can get a better idea of whether it is a good time to invest in the stock market. This seems especially important in light of the recent downturn in the stock market. One thing is for certain, the values in the stock market indexes are lower than they were a year ago.

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