Pros and Cons of Index Funds - Experian (2024)

In this article:

  • Pros of Index Funds
  • Cons of Index Funds
  • Should You Invest in Index Funds?

An index fund is a portfolio of stocks that seeks to mirror the performance of a specific stock market index like the S&P 500 or the Dow Jones Industrial Average. These funds operate on the idea that the larger market will earn higher returns than an individual investment.

Index funds are an effective investment vehicle for many because they are broadly diversified and usually have low fees. Still, these funds have their downsides. Here are the advantages and disadvantages of investing in index funds.

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Pros of Index Funds

Index fund managers aim to duplicate the structure and performance of their target index. For example, the Vanguard S&P 500 Index Fund—an index fund for individual investors—invests in every company listed on the S&P 500 index. Many investors include index funds as core pillars of their portfolios because of the many benefits these funds provide, such as the following.


Index funds are passively managed rather than actively managed. That means index fund managers have a more hands-off approach and invest passively in companies in the market index it follows. Conversely, actively managed funds require the manager to be more involved in researching and choosing which funds to invest in. Because index fund managers don't trade holdings as often as actively managed funds, their management fees tend to be lower.

For example, the management fees, or expense ratio, for the Fidelity 500 Index Fund is a low 0.015%. That means a $10,000 investment in the fund could enable you to enjoy the diversification of the index at a minor management cost of $1.50 annually.


Financial experts consistently advise clients to diversify their portfolios to reduce risk. Since a fund invests in numerous stocks, your portfolio is less likely to be significantly harmed by the poor performance of a single stock.

When you invest in an index fund, you immediately gain access to a large collection of stocks, bonds or other securities, which dilutes your risk. Attempting to accomplish the same diversification to build a similar portfolio on your own would require substantial time and money.

Keep in mind, however, that some indexes are not diversified and invest only in a specific industry or sector.

Long-Term Performance

While performance is never guaranteed, index funds tend to provide more stable and predictable returns over a long-term horizon. Financial advisors have long espoused the long-term benefits of holding index funds for average investors. Accordingly, index funds are often considered an excellent core asset for retirement accounts, including individual retirement accounts (IRAs) and 401(k) accounts.

Billionaire investor and philanthropist Warren Buffett famously advocates for the long-term performance of index funds for the average investor. In a 2013 Shareholder Letter, Buffet revealed his simple instructions for his trustee in his will: "Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund. I believe the trust's long-term results from this policy will be superior to those attained by most investors—whether pension funds, institutions or individuals—who employ high-fee managers."

Cons of Index Funds

The most popular index funds track large sections of the market. Major indexes these funds track include the S&P 500, the Dow Jones Industrial Average, the Russell 2000 and the Nasdaq Composite Index, but index funds also track much smaller indexes. Investing in a large portfolio of equities does have its downsides, including the following.

Less Flexibility

While your portfolio is less affected by a declining singular asset, it's not immune to the fluctuations of the larger market, including economic downturns and bear markets. As such, when the market or sector performs poorly, your index fund will likely follow suit.

Inherently, index funds don't provide the flexibility to quickly respond when the prices of the assets they hold fall. Accordingly, it may be best to maintain a long view with index funds and be prepared for the fluctuations that are sure to come.

Moderate Annual Returns

A single index fund can hold hundreds or even thousands of assets. For example, the Wilshire 5000 tracks all publicly traded companies in the United States. The fund no longer includes 5,000 companies—it currently has around 3,550. The diversification such a large fund provides is immense, but its size also dilutes the possibility of achieving significant annual returns.

Fewer Opportunities for Short-Term Growth

As noted, index funds are widely regarded as long-term investments. But along with that comes slower gains than you may experience investing in individual stocks, options, crypto or other higher-risk investments.

Remember, index funds are passively managed, so there's little chance to make quick adjustments and realize significant short-term gains.

Should You Invest in Index Funds?

As with most investments, deciding whether to invest in index funds comes down to your goals, risk tolerance level and how well a fund fits within your overall financial plan.

Investing in index funds could be beneficial if you want to diversify your portfolio and potentially earn stable returns in the long run. These funds help you access different markets across several sectors and industries, generally at a low cost.

Remember, though, matching your true personal risk tolerance to the risk of an index fund can be difficult. And since the goal of an index fund is to mimic the performance of the index it tracks, any fund you invest in could decline when the market experiences a downturn.

Investing in Your Future

If you want to invest in index funds, there are generally a few ways to do it. You can invest in your employer's retirement plan. If your company doesn't offer one, you can open an IRA and choose index funds as your investment vehicle. You can also invest in index funds through an online brokerage account.

Generally, the more you save and invest, the faster you may grow your wealth. While your financial health is critical, don't forget about your credit health. Maintaining good credit can potentially save you thousands, or even hundreds of thousands of dollars, through potentially lower interest rates on mortgages, car loans and other forms of credit.

Consider checking your credit report and credit score for free with Experian. If necessary, take steps to improve your credit fast to boost your odds of loans and credit line approvals with favorable terms.

Pros and Cons of Index Funds - Experian (2024)


What are the pros and cons of index funds? ›

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).

What are the benefits and disadvantages of an index? ›

Index funds are a low-cost way to invest, provide better returns than most fund managers, and help investors to achieve their goals more consistently. On the other hand, many indexes put too much weight on large-cap stocks and lack the flexibility of managed funds.

What are the pros and cons of real estate index funds? ›

Pros and Cons of REITs
Pros of REITsCons of REITs
High Dividend Yield – Law requires REITs to pay at least 90% of their income in dividends.Interest Rate Sensitivity – REITs use mortgages and other financing arrangements to purchase assets, so they are sensitive to interest rate movements.
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Oct 9, 2023

Should I keep my money in index funds? ›

Index funds are popular with investors because they promise ownership of a wide variety of stocks, greater diversification and lower risk – usually all at a low cost. That's why many investors, especially beginners, find index funds to be superior investments to individual stocks.

What are the benefits of index funds? ›

With advantages like tax benefits, low expense ratios, diversification, and consistent performance in the long run, index funds are a great investment option to help individuals build a strong investment portfolio and secure their future.

What are the pros and cons of bond index funds? ›

Pros and cons of bond funds
You can invest in lots of different bonds at once to spread out your risk.Management fees and sales fees.
Bond funds are typically easier to buy and sell than individual bonds.Less predictable future market value.
Monthly income.No control over capital gains and cost basis.
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What are the negative effects of indexes? ›

While indexes are invaluable for improving query performance, there are downsides. Every index added to a table increases the storage space required by the database. Additionally, indexes can slow down write operations such as INSERT, UPDATE, and DELETE, as each operation requires updating the indexes.

When should indexes be avoided? ›

While indexes are designed to improve the efficiency of a database, there are occasions where they should be avoided, for instance:
  1. On small tables.
  2. Tables that receive a lot of big batch updates or inserts.
  3. Columns that have large numbers of null values.
  4. Columns that are frequently manipulated.
Feb 23, 2023

What are the advantages and disadvantages of index options? ›

Index trading can have multiple benefits. Some of them are: Hedging and Speculation: Investors use index options to gain exposure to the entire market or industry sector through a single transaction. Limited Loss, Unlimited Gain: Loss is capped at the premium paid, while the potential for gains is unlimited.

Are index funds too risky? ›

While they offer advantages like lower risk through diversification and long-term solid returns, index funds are also subject to market swings and lack the flexibility of active management.

What are the pros and cons of investment funds? ›

Some of the advantages of mutual funds include advanced portfolio management, dividend reinvestment, risk reduction, convenience, and fair pricing, while disadvantages include high expense ratios and sales charges, management abuses, tax inefficiency, and poor trade execution.

What is downside protection in index funds? ›

Downside protection strategies involve adjusting a portfolio's market exposure to limit the impact of potential losses from market downturns. These strategies can be applied to different types of asset market exposures, but are most commonly focused on equity, followed by fixed income.

Are index funds 100% safe? ›

Index funds often perform better than actively managed funds over the long-term. Index funds are less expensive than actively managed funds. Index funds typically carry less risk than individual stocks.

Can you live off index funds? ›

Once you have $1 million in assets, you can look seriously at living entirely off the returns of a portfolio. After all, the S&P 500 alone averages 10% returns per year. Setting aside taxes and down-year investment portfolio management, a $1 million index fund could provide $100,000 annually.

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.

What is better a mutual fund or index fund? ›

Index funds offer lower fees and tax efficiency. Due to their passive nature, they often perform in line with market benchmarks, making them suitable for investors seeking broad market exposure at lower costs. On the other hand, active mutual funds aim to outperform the market by employing active management strategies.

Do billionaires invest in index funds? ›

Billionaires Are Selling Nvidia Stock and Buying 2 Top Index Funds That Beat the S&P 500 Over the Past Decade. In this article: NVDA.

Do index funds try to beat the market? ›

Index funds are designed to keep pace with market returns because they try to mirror certain market segments.


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