Index funds offer a simple and cost-effective way to build wealth. If they don’t play a significant role in your overall portfolio, you may want to take a closer look at what a good index fund can do for you.
What index funds do
An index fund is an exchange-traded fund (ETF), or mutual fund that aims to replicate a market index, such as the Nasdaq. Rather than trying to pick only winners, an index fund buys most or all of the securities in the index it tracks, holding them in the same proportions as the index.
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Low costs
One of the strongest arguments for investing in index funds is their expense ratio. The reason active funds tend to have higher expense ratios is that they incur costs for research, trading, and analysis. In contrast, index funds can operate efficiently because their portfolios change only when the indexes they track change.
Those low costs result in compounding in your account over time and allow you to keep more of the market’s returns rather than letting fees slowly erode them.
Diversification
The value of a diversified portfolio cannot be overstated, and index funds provide instant diversification. A broad market fund may hold hundreds or thousands of companies across many regions of the world and sectors. This diversification reduces the impact of a single stock or industry on your portfolio.
Coming out ahead
While there have certainly been periods when active managers have outperformed index funds, most fail to beat comparable indexes over the long term once fees and taxes are factored in. To be clear, index funds don’t promise to outperform actively managed accounts. However, that’s often been the case historically.
Offering simplicity
Index funds make it easy to develop a disciplined plan. You choose how much you want to hold in stocks, bonds, and cash; select a low-cost index fund for each, and rebalance each periodically. This method of investing is about more than being easy or saving time. It also supports these benefits:
- Less temptation to chase performance or time the market, neither of which tends to work out well over time.
- Emotions play a very small role because trading decisions aren’t driven by fear or greed.
- Due to the two benefits named above, there’s a greater likelihood of buying, holding, and allowing compounding to work.
Long-term planning
It’s entirely possible to build a portfolio solely from index funds. Here’s what that may look like:
- A total stock market index fund for broad equity exposure.
- A bond index fund for stability and income.
- Additional index funds as desired for sector-specific and international exposure.
Only you can decide whether an index fund might benefit you as you plan for retirement. The point is to understand what it can do for you and determine if it fits into your plans.