A passive investment method achieved by investing in an index fund
Over 1.8 million professionals use CFI to learn accounting, financial analysis, modeling and more. Start with a free account to explore 20+ always-free courses and hundreds of finance templates and cheat sheets.
What is Index Investing?
Index investing is a passive investment method achieved by investing in an index fund. An index fund is a fund that seeks to generate returns from the broader market by tracking an index. The S&P 500 is the most popular index to track, with a historical annual return of 10%.
Summary
- Index investing is a passive investment method achieved by investing in an index fund.
- The benefits of index investing include low cost, requires little financial knowledge, convenience, and provides diversification.
- Disadvantages include the lack of downside protection, no choice in index composition, and it cannot beat the market (by definition).
- To index invest, find an index, find a fund tracking that index, and then find a broker to buy shares in that fund.
Understanding Index Investing
Index investing falls under passive investing, which involves a buy-and-hold strategy for the long term. On the other hand, active investing is concerned with frequent buying and selling, coupled with continual monitoring of performance.
Exchange-traded funds (ETFs) are the security of choice when index investing. It is because ETFs are passively managed, and therefore low cost – the perfect medium for an index fund.
Advantages of Index Investing
Warren Buffet once said, “A low-cost index fund is the most sensible equity investment for the great majority of investors,” and it’s clear to see why.
- Low cost: Because index funds take a passive approach tracking an index, it has lower management fees than an actively managed fund
- Requires little financial knowledge: Index investing is relatively easy compared to building your own portfolio
- Convenience: Index funds contain hundreds of stocks that would be incredibly hard to replicate at an individual level
- Diversification: Holding a large array of stocks diversifies away idiosyncratic (firm-specific) risk
Disadvantages of Index Investing
- Lack of downside protection: There is no floor to losses
- No choice in the index fund’s composition: Cannot add or remove any holdings
- Can’t beat the market: Can only achieve market returns (generally)
How to Start Index Investing
Step 1
The first step to index investing is choosing the right index for your preferences. As mentioned, a common index to track is the S&P 500, an index composed of 500 large U.S. companies. Other popular indexes include the Dow Jones Industrial Average (DJIA), a composite of 30 US large-cap companies, and the NASDAQ Composite, another U.S.-based index that is heavily weighted in the IT sector. The U.S. market is often used synonymously as the broad market because of its importance and influence as a financial hub.
For individuals with more advanced financial knowledge, index investing can be a very useful tool to potentially “beat the market.” If you expect a particular region, sector, or factor to outperform, you can choose to invest in an index that specializes in such areas. For example, if you expect Asia to outperform in the future, you may look into tracking an Asian index. Popular indexes include:
- Shanghai SE Composite Index (China)
- Hang Seng Index (Hong Kong)
- Nikkei 225 (Japan)
The stock market is comprised of 11 sectors, formally known as the Global Industry Classification Standard (GICS). Such sectors include IT, healthcare, consumer discretionary, energy, industrials, and more. There are many available sector indexes that can be benchmarked.
Lastly, a factor is an attribute that’s been historically proven to provide excess returns across assets. Some identified factors include:
- Value
- Size
- Quality
- Momentum
- Volatility
- Growth
Each factor performs well at different points in the business cycle. If you feel confident of any specific factor, you can target it by buying into a factor index.
Of course, it should be noted that investing in a specific area will increase your risk. It is because if you choose to go overweight in a specific region/sector/factor and it ends up doing poorly, all your investments will suffer as a result. Nevertheless, higher risk comes with a higher return, so if you bet on a specific area that performs favorably, you can beat the broad market.
Step 2
The second step is to choose a fund that tracks such an index. There are many ETF providers that will have similar offerings with slight variations, so it is wise to do research into the differences. Such differences could be the expense ratio, dividend yield, performance, and more.
Step 3
The last step is to buy shares from your chosen index fund. To do so, you must open an account through a broker. Again, every broker may offer different benefits and drawbacks, so it is important to compare before jumping in.
More Resources
CFI is the official provider of the Capital Markets & Securities Analyst (CMSA)® certification program, designed to transform anyone into a world-class financial analyst.
In order to help you become a world-class financial analyst and advance your career to your fullest potential, these additional resources will be very helpful:
FAQs
Index funds are simple, low-cost ways to gain exposure to markets. They're most commonly available as mutual funds and exchange traded funds (ETFs). While stocks, bonds, commodities and real estate have been around for centuries, index funds have revolutionized how investors access these assets.
Is it a good idea to invest in index funds? ›
Index funds can be an excellent option for beginners stepping into the investment world. They are a simple, cost-effective way to hold a broad range of stocks or bonds that mimic a specific benchmark index, meaning they are diversified.
How risky is index investing? ›
Asset prices can rise and fall rapidly and investors must accept the fact that the value of their index based investment may fluctuate by as much as 50% or more in a year. General market risk can relate to a particular sector. For example, mining sector indices are usually more volatile than industrial sector indices.
Is an S and P 500 index a good investment? ›
Bottom line. S&P 500 index funds are some of the best investments for investors of all skill levels, but they can be especially beneficial for newer investors, who can enjoy solid returns without needing extensive expertise. Investors have a variety of cheap options to attain those tasty returns.
How to invest in index funds for beginners? ›
You can directly invest in index funds by opening and funding a brokerage account. All brokers allow you to directly buy shares of ETFs on the open market, and most allow you to directly invest in mutual funds if you prefer to use those.
Is there a downside to index funds? ›
While index funds do have benefits, they also have drawbacks to understand before investing. An index fund tends to include both high- and low-performing stocks and bonds in the index it's tracking. Any returns you earn would be an average of them all.
Do billionaires invest in index funds? ›
The bottom line is that even billionaires recognize the wealth-creation potential of low-cost index funds. Even if you're an active investor in individual stocks -- like Buffett and Dalio are -- rock-solid index funds like these four can help form an excellent backbone for your portfolio.
How long should you hold index funds? ›
Ideally, you should stay invested in equity index funds for the long run, i.e., at least 7 years. That is because investing in any equity instrument for the short-term is fraught with risks. And as we saw, the chances of getting positive returns improve when you give time to your investments.
How likely is it to lose money in a index fund? ›
All investments carry risk. An index fund, like anything else, can potentially lose value over time. That being said, most mainstream index funds are generally considered a conservative way to invest in equities (although there are lesser-known index funds that are thought to carry greater risk).
Do index funds ever fail? ›
Much of it, yes, but not entirely. In a broad-based sell-off of a market, the benchmark index will lose value accordingly. That means an index fund tied to the benchmark will also lose value.
Over the past decade, you would have done even better, as the S&P 500 posted an average annual return of a whopping 12.68%. Here's how much your account balance would be now if you were invested over the past 10 years: $1,000 would grow to $3,300. $5,000 would grow to $16,498.
How much money was $1000 invested in the S&P 500 in 1980? ›
In 1980, had you invested a mere $1,000 in what went on to become the top-performing stock of S&P 500 (^GSPC 0.09%), then you would be sitting on a cool $1.2 million today. That equates to a total return of 120,936%.
What is the 20 year return of the S&P 500? ›
Average returns
| Period | Average annualised return | Total return |
|---|
| Last year | 25.7% | 25.7% |
| Last 5 years | 14.2% | 94.5% |
| Last 10 years | 15.3% | 316.2% |
| Last 20 years | 10.6% | 651.5% |
Investment minimums: Many mutual funds have a minimum investment amount for your first purchase, often several thousand dollars. In contrast, many ETFs have no such rule, and your broker may even allow you to buy fractional shares with just a few dollars.
How do you actually make money from index funds? ›
As with other mutual funds, when you buy shares in an index fund you're pooling your money with other investors. The pool of money is used to purchase a portfolio of assets that duplicates the performance of the target index. Dividends, interest and capital gains are paid out to investors regularly.
Can I buy index funds without a broker? ›
Deciding where to buy your index funds
First, you'll have to choose a brokerage. Charles Schwab, Fidelity and Vanguard are some of the biggest brokerages where a do-it-yourself investor can open an account. Also, companies like Betterment offer fully automated index-fund investing through ETFs.
Is it better to invest in index funds or stocks? ›
The stock market has proved to be a great investment in the long run, but over the years it has had its fair share of bumps and bruises. Investing in an index fund, such as one that tracks the S&P 500, will give you the upside when the market is doing well, but also leaves you completely vulnerable to the downside.
Is it better to invest in index funds or mutual funds? ›
Diversification Shortcut: Index funds passively track benchmarks; mutual funds aim to outperform. Investment Accessibility: Invest in mutual funds via company or trade ETFs like stocks for added convenience. Cost and Performance: Index funds cost less, have lower taxes. Most prefer them for cost-effectiveness.
What is the average return on index funds? ›
The average stock market return is about 10% per year, as measured by the S&P 500 index, but that 10% average rate is reduced by inflation. Investors can expect to lose purchasing power of 2% to 3% every year due to inflation. » Learn about purchasing power with the inflation calculator.
What does Warren Buffett suggest to invest in? ›
Key Points. Warren Buffett made his fortune by investing in individual companies with great long-term advantages. But his top recommendation for anyone is to buy a simple index fund. Buffett's recommendation underscores the importance of diversification.
