Financial Literacy Friday: Index Funds
Hello everyone and welcome back to another edition Financial Literacy Friday where today we’ll be talking about index funds. Index funds were made popular but Warren Buffet and were made easily accessible by Vanguard and other mutual fund companies. They were also promoted by John Oliver on Last Week Tonight about personal finance for those of you who watch his show. Given their rising popularity, I wanted to write a post about them so you can be knowledgeable the next time they come up in conversation.
Before we get into what an index fund is and how they operate, it may be helpful to become more familiar with the first word, index. A market index is the weighted average of a group of stocks or other investments that comes from a section of the stock market. For example, the S&P 500 is 500 companies taken from the stock market and makes up that index. Obviously there are more than 500 companies that you can invest in, but those 500 are pulled together to create the S&P 500 index, and by investing in that index, you’re investing in those 500 companies. That’s an all index is, it’s a grouping of investments that fit certain criteria to be included. So, let’s look at how an index fund works.
An index fund is a mutual fund who’s portfolio matches that of a specific index. So if you bought an index fund of the S&P 500, that fund would track that index and buy every company of those 500. There are a number of advantages to this:
They’re low cost because there are very few transaction fees. They buy those companies, hold them until the index gets rebalanced, and then buy and sell whatever is phased in or out.
Provides a good amount of diversification as your investment is spread across 500 companies instead of just a few if you were buying individual stocks.
Because they only get rebalanced at certain times during the year, there’s very low turnover in the funds as there aren’t many opportunities for that to happen.
Index funds are effective because if you take a broad enough corner of the market and have a large enough time horizon, they will eventually perform well and generate returns as the market generally goes up over time. For those who are starting out in their investment experience, they can be a good option as they are very low cost and provide decent returns without a lot of complicated bells and whistles. They are a great entry point into the world of investing and because of their relatively simple strategy they allow for people to truly understand what’s happening.