Could Index Funds Be the Missing Piece in Your Financial Plan?

Hi Reader,

Welcome to The Money Series and if you are new here, thank you for signing up. Personal Finance can feel ambiguous and overwhelming, but I am here to help simplify the journey.

Today, we continue our investing radar by exploring Index Funds.

An index fund seeks to mirror the returns of an existing index. An index is a list of companies in the capital market used to measure how a part of the market is doing. For example, the S&P 500 tracks 500 big companies in the U.S. to give an idea of how the market is performing. An equities index fund is an investment that follows an equity index. The fund buys the same stocks as the index, so its performance matches the segment of the market that the index represents.

These funds adjust their investments only when a stock is added or removed from the index. The goal is simple: match the performance of the index. Unlike a single stock which represents one company, an index fund represents many. This diversification means your investment's performance is tied to the collective performance of all the companies in the index.

Because index funds replicate an existing index without a manager actively selecting stocks, they come with lower management costs. Additionally, advances in technology and automation have further reduced the cost of managing these funds. The S&P 500 index is one of the most followed and widely recognized indices in the world and it’s currently my favorite index for passive investment in the stock market. The index covers approximately 80% of U.S. equities and 50% of global equities by market capitalization, including some of the world’s most influential companies.

Why Choose Index Funds (using the S&P 500 index as a case study):

• Diversification and Lower Risk Compared to Individual Stocks. Investing in an index fund like the S&P 500 spreads your risk across 500 of the largest publicly traded companies in the U.S. across various industries, such as technology, healthcare, financials, and consumer goods. This broad exposure reduces the risk associated with investing in a single company or sector.

• Long-term growth potential. The US S&P 500 index has returned an average of 12% annually over the last decade and about 10% from inception. While returns vary year by year, the long-term trend has been positive. Index funds especially have higher returns when the market is experiencing an uptrend. Below is the chart of the S&P 500 index performance since inception.

Although there have been periods where the index value reduced (mostly during economic recessions), there has been an upward movement.

• A passive form of investing. Index funds are a great way to be a hands-off, stress-free investor. Once you invest in an index fund, your job is done. You don't have to track the performance, research individual stocks, or read financial reports.

• Highly Liquid: Given that the S&P 500 index consists of highly traded stocks, index funds tracking the S&P 500 index are highly liquid, allowing you to withdraw your funds easily and quickly. You can enter or exit your position quickly with minimal costs, making S&P 500 funds a convenient choice for short-term traders and long-term investors.

• Low-Cost Investment: Many index funds that track the S&P 500 have low expense ratios. Index funds offered by Vanguard or Fidelity have expense ratios as low as 0.03%. If you invest $10,000 in a fund with a 0.03% expense ratio, you’ll pay $3 annually in fees.

Even Warren Buffet, a legendary investor, advocates for index funds. In 2007, he placed a million-dollar bet that his S&P 500 index fund portfolio would beat an actively managed hedge fund (Protégé Partners) over 10 years and won! His S&P 500 index fund returned 7.1% annually over 10 years*, beating an average increase of 2.2% by the basket of funds selected by Protégé Partners.

Things to Note when Investing in Index Funds:

• Limited Outperformance. Index funds are designed to match, not beat, their benchmark. This means they’re unlikely to outperform the market significantly.

• Potential Missed Opportunities. You might miss out on massive gains from a potential ‘Magnificent 7’ since popular indexes often focus on established firms rather than newly listed, high-growth companies.

• Investing in index funds can be quite boring. If you enjoy the thrill of stock price swings, index funds may not be for you. Index funds are best suited for a set-it-and-forget-it approach to stock market investments.

• Best Suited for Long-Term Investing. Index funds aren’t ideal for those seeking quick wins or market timing. Based on the historical performance in the chart above, you are better off investing for a few years, at least, to ride the wave and record positive performance

• Expense ratios. The management fee paid to the investment managers. The lower the better, choose funds with expense ratios of 0.05% or less.

• Transaction Fees. These are usually noted in the fund prospectus - lower fees are always better.

• Minimum investments. Some index funds have a minimum investment requirement, while others allow any amount.

If you live in a country with a stable currency, an active stock market, and a diversified market index, consider funds that track your local index. See here a list of other market indexes you can consider for investment.

Passive investing is a personal choice. If you're trying to invest your money in funds that do not require your attention, effort, and focus, then index funds may be a perfect fit.

Feel free to send in your questions; they might influence the next newsletter!

Act Now:

• If passive investing appeals to you, choose an index fund that suits your needs.

Reflect on This:

• When investing, do you prefer taking charge or earning steady returns passively?

Till next week, I am rooting for you, money-ly!

Dee

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Disclaimer: This does not constitute financial advice. Please conduct your research or consult your financial advisor for important financial advice.