Advantages of Index Investing
What Index Investing Means?
Index Investing is a form of passive investing that aims to generate profits by mimicking the return rate of a particular market index. In other words, it is a type of investment that focuses on a whole market index rather than on specific stocks. There are two ways of doing so: index funds and exchange-traded funds, commonly known as ETFs. Index investing funds are generally related to retirement accounts such as IRAs and 401(k)s, being the core of many investors’ portfolios.
How Index Investing Works?
When we see the words ‘invest’ and ‘market’ our minds immediately bring us the image of Michael Douglas and Charlie Sheen running up and down, selling and buying stocks from an office full of computers vomiting graphs and statistics while shouting on the phone to rush someone to close a deal to beat the market and make the fortune of their lives.
Well, all that drama and stress can be avoided by giving a new meaning to the words ‘invest’ and ‘market’. Nowadays, many people do not want to risk their investments by trusting their or someone else’s instincts when betting money on a company’s growth. The alternative to that risk is called index investing and allows individuals to place their money on funds that replicate a whole market for example, the U.S. stock market. That means the investor does not need to pray for a company’s growth to see their money raise; they only need to trust a whole market to grow no matters which companies do better and which ones do worse.
That is easier to achieve than making money on the traditional stock market although an investor taking risks on the latter could make much more money on a single investment than someone investing on the whole U.S. market or on a foreign stock market. Let’s say index investing is less risky and more balanced than actively-managed investing.
Advantages of investing on index funds vs. actively-managed funds
As said before, index investing is a form of passive investment, so that is the first and the main difference when compared to the classic form of investment on stock funds. Being a passive investment means there is no need to research and select specific stocks so it is from that unneeded process that the first advantage comes: lower costs fund’s expense ratio for the investor: less fees, less taxes, etc. Index investing is widely known as a low-cost form of investment because of this.
The diversification of the investments is another difference and supposedly advantage of index investing against traditional actively-managed investments. It is said that diversification is the only way to decrease the investment risk without decreasing the expected return. This happens because we are spreading the invested money instead of putting everything on a few stocks that can go wrong and make us lose everything. Putting money on many different stocks give us a bigger chance of getting a positive return making exactly the same initial investment.
Finally, we will refer to these investments’ consistency. Traditional stock markets are flooded with greedy and impulsive people who could lead an investor to make very bad decisions. One of the keys to be successful when investing is to stick to the plan and discard any impulsive or unreasonable behavior. Index investing is perfect for that as there will be no individuals trying to persuade us to make rushed decisions once we pick a market we want to track with our index investment.