The world of investing doesn’t solely revolve around individual stocks. There are several other investing vehicles out there. Some of the most popular include Mutual Funds, Exchange Traded Funds (ETFs), and today’s topic – Index Funds.
Some people may not have the time, patience, or passion to research individual companies and, subsequently, invest in individual stocks – and that’s okay! Index Funds provide a great way to still participate in the stock market and create wealth slowly but surely over the years without the added ‘pressure’ of having to choose individual companies to build a portfolio.
Let’s start with the basics …
What is an Index Fund?
You can think of an Index Fund as a “basket of stocks”. Basically, an Index Fund tracks the performance of various companies all at once. The return on investment someone can get from purchasing an Index Fund will depend on the performance (on average) of all the companies in that basket. The most commonly followed (and purchased) Index Funds track the S&P 500.
Wait – what is the S&P 500?
Glad you asked 🙂 … The S&P 500 is an index composed of the 500 largest companies in the U.S. representing leading industries including Industrials, Technology, Energy, Materials, Consumer Goods, Financials, Consumer Staples, and Utilities. Because the S&P 500 is such a broad index that includes so many businesses, it is the primary benchmark used by most analysts and investors. For that reason, the S&P is often referred to as “The Market” or “The Market Index”. If you are wondering which businesses are included in the S&P, you can check out a full list here.
So, for example, let’s say that you choose to invest in an Index Fund that follows the S&P 500, that particular investment you made will increase or decrease in value in accordance to the market average performance. In other words, you cannot outperform or underperform the market.
If the market is doing well, with healthy average gains over time and the occasional down-turn, your investment will perform the same way.
The key word here is average. By owning an Index Fund, you are okay with average market returns. This is actually perfectly okay considering that Index Fund returns are usually (a lot) higher than having your Investing-Fund money under your mattress or sitting in a bank account collecting pennies on the dollar. Or worse – decreasing in value due to inflation.
How exactly does an Index Fund differ from buying an individual stock?
While Index Funds are synonym to average market returns or average return of multiple businesses; when you invest in an Individual Stock you are investing in one single company. The returns on your investment has the potential to do a lot better than the market as a whole or a lot worse depending on the performance of that stock.
While an index fund can provide a return of 7% over the course of one year or ten; an individual stock has the potential of returning 20% in one single day. It also has the potential to decrease by 20% in the same amount of time. Stocks are risky. There is no way to sugar coat this. However, they also have the potential for great returns.
Side bar – One of the ways investors of individual stocks protect themselves from the risk that comes with investing in one single company is by investing in various individual stocks. This help lessen the blow when a particular company is doing poorly.
Real Life Examples
As always, the examples below are for educational purposes only and are by no means recommendations of any kind. I simply want to give you a clear view of the differences in returns from Index Funds vs. Stocks.
These are generalized and simplified examples.
Exhibit I: A very popular standard Index Fund is the Vanguard S&P 500 index fund (VFINX). Over the course of 3 years, this fund has generated an average return of 9.46% for their investors. Source: Vanguard.
Exhibit II: Meanwhile, companies like Nike, Facebook and Amazon have generated returns of 15.59%, 31.36%, and 47.79% respectively over the same 3 years. Source: Morningstar.com
Exhibit III: On the other hand, companies like Pandora, Twitter, or Sears have declined by -27.9%, -23.87% and -36.59% respectively over the same time 3-year period. Source: Morningstar.com
In the first example, individual stocks are obviously the winners by a long shot. Meanwhile, in the second example, we would have been better off putting our money in the Index Funds.
There are hundreds of similar examples like the ones shown above (many are found in my book). Things can go either way depending on where you choose to put your money and what ends up happening with those companies.
Remember nobody can tell what will happen when it comes to market performance or individual stock performance. If we did, we’d all be billionaires. Also, past performance is never a guarantee of future results, so you can’t assume that because a stock went up by 20% one year, the same thing will happen the following year.
Question: How do you feel about Index Funds now that you know more about them? Is this the type of investment you would consider? Why or why not? Share below or head over to the Facebook Group and join the discussion! =)
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Guides that will soon be available to the public:
- Understanding Annual Reports
- Index Funds Explained
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