Understanding Index Funds: The Smart Way to Invest for Beginners

Introduction

Ever wonder how some people stay on track building their wealth without gambling crazily? For many, the secret is through index funds. But if the term "index fund" is just financial jargon to you, don't worry; you're not alone. And if you're completely new to investing, you might want to check out our Beginner's Guide to Investment, to get a handle on the fundamentals before diving in. But don’t worry, investing in index funds is way easier than it sounds and one of the smartest, easiest ways to get your money working for you. Because of their simplicity, low costs, and solid returns, these funds appeal both to the newbie investor and seasoned pro alike. 

Anyway, here we are. Index funds–what are they, and why should you invest in them? This article is going to break it down and explain why index funds could be your ideal fit for your investment journey.

What Are Index Funds?

You might have come across this term now and then, especially if you are just starting to invest. But just what is an index fund?

An index fund, in simple terms, is an investment pool that tries to match or mirror the return of a particular market index, say the S&P 500. A market index is a portfolio of either stocks or bonds representative of a section of the market. It does not try to pick the best individual stocks. It does this by investing in that index's entire pool of stocks or bonds, hence letting you invest in a wide swath of companies with just one single, easy investment.

It is better to think about it as buying one small piece of lots of companies and not putting money into just one company. That somehow seems to reduce the risks because when one turns out bad, others could be better, thus balancing everything.

Example: The S&P 500 index is one of the most popularly known indexes in the stock market, which covers the stock performances of 500 of the largest companies in the United States, such as Apple, Microsoft, and Amazon. When you invest in an S&P 500 index fund, your money is given broad diversification among those companies to make a beneficial return from the general performance of the U.S. stock market.

Why Index Funds Are Ideal for Beginners

Why does everybody talk about index funds? Well, here are the reasons.

1. Lower Cost: One of the reasons index funds are so friendly to beginners is that they include lower fees than those of actively managed funds. Because an index fund simply measures an index and doesn't hire expensive managers to pick stocks for them, they save you money in the long run.

2. Diversification: As earlier stated, investment in an index fund means investing in a wide variety of companies from one market index. What it means is that you spread your risk by not depending on the success of that one company or industry.

3. Minimal Effort: Once you've chosen an index fund, there's no need to continue to spend time pondering over which stocks to buy and sell. An index fund is perfect for an extremely hands-off investment strategy; in this case, it's set it and forget it, and let your investment grow.

4. Solid Growth: While index funds will take hits during market slumps, they have a general tendency to rise over time. Because an index fund follows the overall market, it has offered consistent returns in the past, thus making the fund a sure deal for the long-term investor.

Key Advantages of Index Fund Investment for Beginners

1. Ease: Once set up, index funds take minimal ongoing work. That is, they are perfect for those beginners who either don't have the time or the experience to manage their investments actively.

2. Less Stress: You're diversifying into a bunch of companies, so you aren't putting all your eggs in one basket. When one company is doing terribly, others may do well and balance out.

3. Long-Term Growth: While there will be ups and downs, index funds usually grow over time and are generally a good choice to be made for any long-term investor.

The Potential Downsides of Index Funds

1. No Control Over Holdings: Perhaps the one drawback with index funds, otherwise great for novices in investing, is that you have no control over choosing which particular stocks or bonds you're investing in. Of course, when one company within that index just so happens to not do well, it will still hurt your fund due to being in that index.

2. Market-Driven Performance: Since index funds are designed to track the market when that market goes down, so will your index fund. There is, however, no option of avoiding any poor-performance company in an index fund, as might be the case with a managed fund. Remember, though, that over time, the market has bounced back, so this is more of a short-term risk.

Conclusion

If you are starting to invest and want to keep things super simple, index funds are the way to go. By highly diversifying your investments with very little effort and minimal costs, you will be able to have high returns. Do start early by contributing a small amount often, and then let your money grow to set yourself up for long-term success in financing.

Ready to take it one notch higher? In our next piece, we discuss How to Invest in Index Funds for Beginners. We are going to take you through a step-by-step process on how to go about selecting the right fund down to making your very first investment and mention some common mistakes to avoid. Make sure to keep an eye out on this space for a step-by-step, practical guide on how to kick-start your index fund investing.