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When it comes to financial education, there is one concept that you have to totally get if you are even thinking about investing in the stock market either alone or with a financial advisor. That concept is index funds.
Index funds are the starting point for investment education, and they are important to understand for 2 major reasons.
First, they make a great investing tool.
Second, they are used as a measure for ANY investment you make.
In this article I’ll explain what index funds are and why they are so popular for both individual investors and financial advisors.
I like to equate index funds to your total wardrobe; your wardrobe consists of blouses, tees, shoes, boots, dresses, and so on. The totality of all of these pieces is called your wardrobe. While you may buy an outfit, you probably frequently buy one piece at a time.
But, you could call Nordstrom’s and say to a personal shopper: “I want to spend $25,000 for a complete wardrobe, size 6, for an entrepreneur woman who lives in Austin, Texas.”
(You actually can do this, and it sounds very fun, right? But, not to digress to clothes talk, which I do enjoy:)
So, an index fund is like a wardrobe because it is made up of a bunch of different stocks, just like your wardrobe is made up of different pieces which can, and usually are, purchased separately; but for ease, your wardrobe could also be bought in one big purchase as in the Nordstrom example.
An index funds allows an investor to easily buy a group of stocks with an index fund.
A stock index is a pool, or basket of stocks that represents a market or a segment of that market. Common stock indexes that you have probably heard of are the Standard and Poor’s 500 and the Dow Jones Industrial Average. The S&P 500, for example, is made up of 500 large U.S. based companies that represent the U.S. stock market.
You’ve probably heard many times the index used as a reference to how to the overall market did for a certain day, such as “the S&P was up 53 points today”.
Here is how index funds work; let’s say that you wanted to invest $100,000 in the stock market. But you may want to lower your risk by buying a group of different stocks, maybe stocks in 10 companies. So, you would then research every company and choose the stocks that you wanted to buy in your investment account.
But you would still have $10,000 in each company. That could be a lot, depending on what per cent the $10,000 is of your net worth.
What if you could take that same $100,000 and invest in dozens or even hundreds of different stocks by buying just one investment? That is exactly what an index fund allows investors to do.
You are familiar with mutual funds, right? Index funds are a type of mutual funds.
Every index mutual fund mimics a particular index, allowing investors to buy the index as a whole through a mutual fund. There are several reasons why index investing has grown astronomically in popularity with individual investors over the past two decades.
- Index funds are simple. If you wanted to make a diversified investment in the US stock market, but didn’t want to research and track a lot of different companies, then you could buy the S&P 500 index. You would then own a tiny piece of each of those 500 companies through a fund.
- Index funds can be very low cost, since no research team is needed to identify the stocks that need to be bought. The fund just buys the companies in the index.
- Index funds are tax efficient, since the only time stocks are bought and sold within the fund is when the index changes the holdings, which is rare.
- The minimum requirement amounts for index funds are very small. This can make them well suited for someone who doesn’t have enough money to work with a financial advisor, or who wants to manage at least a portion of her own money.
Remember, it’s the money that you keep after related costs that grows. Index funds can be an excellent way to invest. Enhancing an index strategy with scheduled re-balancing or taking advantage of market cycles can add an extra boost to your investment plan while also reducing risk.
Two huge things to remember:
First, always see where the cycle is before investing in anything, meaning, is at the very top of a 3 year cycle?
Second, please remember….there is much more to know! I don’t give investment advice….I provide financial education so you can make more informed and confident decisions either with a financial advisor or as an individual investor after you have thoroughly researched an investing strategy.