When you think about the stock market, you likely think about a system of individual stocks in which investors buy pieces of companies in an attempt to generate profits. Unfortunately, this system is intimidating to many who know that losses are commonplace and that picking great stocks is difficult even for professionals.
However, you don’t have to be a guru with years of experience in financial markets to make meaningful profits on Wall Street. In fact, you don’t even have to take part in deciding which stocks you’ll hold in your investment portfolio or take an active role in managing those investments at all. You can instead use what’s known as the index investing strategy.
What Is the Index Investing Strategy?
Investors who take part in indexing aren’t interested in doing the research required to choose stocks one by one. Instead, index investors nest their money in index funds and passively managed exchange-traded funds (ETFs).
These investment-grade funds use investment dollars collected from a large group of investors to purchase a diversified group of stocks that track the results of a market index.
Unlike active funds, the fund managers at the helm of passive funds don’t choose individual stocks to invest in. Instead, they make investments in an attempt to match the results of the underlying benchmark index they track.
For example, an S&P 500 index fund that’s designed to give investors broad market exposure would invest in every stock listed on the S&P 500. When the companies that make up the S&P 500 change, the index fund will make adjustments to match and keep returns in line with its benchmark.
All told, the index investment strategy gives retail investors the ability to invest in a broad list of diversified stocks without the intense research that comes along with managing stocks on an individual basis.
Pros & Cons of Index Investing
This strategy has become overwhelmingly popular and, in the market, popularity isn’t something that happens without good reason. You can rest assured that there is plenty to like about indexing. However, as with any other strategy, there are both pros and cons to consider.
Here are the most significant benefits and drawbacks of following this strategy.
Indexing Pros
Using index funds to invest in the stock market is overwhelmingly popular. According to Bloomberg, more than 50% of the overall value held in the market is held in passive investments. Even famed investor Warren Buffett recommends indexing as a sensible way for the majority of investors to participate in the gains enjoyed by Wall Street.
There are plenty of perks to following a passive strategy like this. Some of the most important include:
1. Diversification
When investing in index funds, you’ll gain exposure to every asset listed on the underlying index the fund is centered around. This means that your portfolio will be heavily diversified, offering you a sense of security. After all, if one or two stocks in the portfolio take a significant hit, gains in the other stocks will offset the declines.
2. Lower Costs
Index funds tend to be much less expensive to own than actively managed mutual funds, represented by a lower expense ratio. And although you will still pay fees when investing in index funds, the cost is minimal compared to the transaction fees you would pay to invest in every individual stock these funds hold.
As a result, the cost associated with investing is greatly reduced when taking advantage of this strategy.
3. Easy to Manage
Investing is a process that takes quite a bit of time. After all, if you invest in a long list of stocks, you’ll have to do quite a bit of research before entering your positions. Moreover, you’ll have to keep track of what’s going on with each of those stocks, further adding to the time commitment.
While some research is required when choosing strong passive funds to invest in, the time commitment is greatly reduced when following an indexing strategy.
4. Requires No Expertise
Not only do you have to commit a significant amount of time to research and portfolio management when investing in stocks you choose on an individual basis, you’ll have to have the know-how to make smart investment decisions, which is a major barrier to entry for beginners.
However, with the index investing strategy, fund managers do all the leg work, making it a great option for those who want to get involved in the market but don’t quite have the expertise to feel comfortable choosing their own stocks.
Indexing Cons
While there are plenty of reasons to be excited about jumping into a passive strategy like indexing, there are also some drawbacks investors should consider before getting involved. Some of the most important include:
1. Lack of Control
When purchasing index funds, you have no control over the stocks that are purchased on your behalf. The fund will purchase all the shares needed to track the underlying index, which may include some business you wouldn’t ordinarily want to own.
Moreover, when you own individual shares of a company, your vote counts, giving you some control over how the company operates its business. However, when those shares are purchased through a fund, your vote is controlled by the fund manager, who may not share your views when making your votes for you.
2. It’s Tough to Beat the Market
Beating the market is a common goal among investors. After all, who doesn’t want their returns to outpace market averages?
While some passive funds can beat the market, the vast majority have a goal of staying in line with average returns, meaning you can’t expect to generate any more of a return than the average investor. These investments are generally so diversified that it’s impossible to beat the market because your portfolio will become a representation of the market as a whole.
How to Choose the Best Index Funds
As with stocks, not all index funds are created equal. While you won’t have to do as much research when investing in these funds as you would if you choose your own stocks, it’s important to do a bit of research to understand exactly what you’re buying before you make the purchase.
When deciding which funds to dive into, follow these steps:
1. Choose the Types of Stocks You’re Interested In
There are several different types of index funds out there, each designed to track a specific index.
The most basic indexing strategy is to simply choose a fund that tracks the total stock market or the S&P 500. There are several low-cost total market index fund options from popular investment managers like Vanguard, Schwab, and Fidelity. Any one of these will give you broad exposure to the entire U.S. stock market.
Some index investors stop there and call it a day. But you can also use index investing to put some or all of your portfolio into certain types of holdings.
For example, if you’re interested in investing in large-cap stocks that represent large, stable companies, you may want to consider investing in a fund that’s centered around the Dow Jones Industrial Average market index. On the other hand, if you want to invest in smaller companies, you may want to look into small-cap funds centered around the Russell 2000, a small-cap stock index.
Market capitalizations aren’t the only factors indexes are centered around either. There are plenty of indexes and index funds centered around other investing strategies. For example:
- International Investments: If you’d like to add international exposure to your investment portfolio, consider investing in a fund centered around the EAFE index, which is focused on stocks in Europe, Australasia, and the Far East.
- Emerging Markets: If you’re interested in emerging market investments, look for a fund that’s based on the MSCI emerging markets index, a stock market index that tracks stocks in emerging economies around the world.
- Growth Stocks: There are several growth indexes and even more index funds centered around them. Two of the most commonly followed indexes that track growth stocks include the Dow Jones U.S. Large-Cap Growth Total Stock Market Index and the Russell 3000 Growth Index.
- Value Stocks: There are also several market indexes that track value stocks. Some of the most popular include the Russell 3000 Value, Russell Mid-Cap Value, and the CRSP Small-Cap Value.
- Income Stocks: There are plenty of indexes centered around stocks known for paying dividends. Some of the most popular include the S&P 500 Dividend Aristocrats and the S&P High-Yield Dividend Aristocrats.
2. Make a List of Index Funds that Invest In the Stocks You’re Interested In
Once you’ve decided what types of stocks you’d like to have in your portfolio, it’s time to make a list of options to compare. To come up with a list of funds that fit well with your goals, start with a search on your favorite search engine.
For example, if you’re interested in small-cap value stocks, do a search for “best small-cap value index funds.” You’ll likely be surprised at how many are out there. Make a list of five to 10 options you’d like to compare.
3. Compare Expense Ratios
As mentioned above, investing in index funds is a low-cost option, but that doesn’t mean it’s free. Index funds and other investment-grade funds charge annual management fees known as expense ratios. The higher these fees are, the more they tap into your gains to pay their expenses.
Over the long run, these fees can make a significant difference in how well your investments perform.
The average index fund comes with an annual cost of around 0.2%, but that shouldn’t be your baseline. There are plenty of fund managers, like Vanguard and Fidelity, that pride themselves on offering low-cost access to the market. Some funds with these providers have fees under 0.05%, which is significantly lower than the national average.
Some specialized index funds, such as those that track international indexes, may come with slightly higher management fees. Be sure to evaluate the funds on your list against other funds that track the same types of stocks to compare apples to apples.
Comb through your list of funds and see which options come with the lowest expense ratios. Those that charge higher-than-average fees can be scratched off the list.
4. Compare Historic Performance
Whether you’re investing in investment-grade funds or picking stocks on a one-by-one basis, your goal is to make money. Although index funds are designed to track the returns of an underlying index, some do a better job than others, meaning that some will outperform others in terms of returns.
Before diving into any fund, compare the average annual returns of the funds on your list to find the funds that are known to produce the biggest gains.
5. Compare Dividend Yields
Many stocks pay dividends, which are simply a percentage of profits earned that are paid directly to investors. Of course, no stock is required to pay dividends, and the amount of dividends paid is completely up to each company.
When it comes to index funds, dividends paid by the stocks the fund owns are passed along to the fund’s investors based on the number of shares they own. If you need to generate income from your investments, it’s important to compare the dividend yield for each option on your list to determine which funds pay the most income.
Funds typically list their dividend yield as an annual percentage, much like an individual stock. Most index funds pay dividends quarterly, but some may pay out at different intervals.
6. Compare Morningstar Return Ratings
Morningstar is a financial firm that created the Morningstar Return Rating, designed to show investors how funds compare to others in their industry in terms of overall long-term returns. The data is crunched and displayed to investors in a simple-to-understand five-star rating format.
Many factors go into these ratings, and even professional analysts can get things wrong, so it’s not the case that a five-star rated fund will always outperform a three-star rated one. But Morningstar ratings are a useful gauge of any fund’s recent performance. With few exceptions, investors should avoid the vast majority of funds with a Morningstar Return Rating of two stars or lower.
7. Compare Fund Popularity
In a way, the stock market is a popularity contest. The most popular assets on the market are highly liquid, meaning that when investors feel it’s time to exit their positions, they’ll be able to do so, because there will always be someone ready to buy the shares they decide to offload.
Unfortunately, that’s not the case when it comes to unpopular assets.
Before diving into a fund, it’s important to consider how popular it is among the investing community. One of the best ways to tell is to look at the size of the fund, measured by assets under management, or AUM.
Smaller funds with few assets under management haven’t attracted the interest of the masses, and therefore it may be difficult to exit your position when you feel the time has come.
Focus the brunt of your portfolio’s assets on funds that have the largest amount of assets under management to ensure that you don’t get stuck holding the bag when it’s time to sell.
Don’t Forget Bond Allocation
As you invest, you’ll find that stocks aren’t the only important assets to hold in your portfolio. Stocks are highly volatile and a portfolio made up of 100% stocks will come with significant drawdown risk.
To offset that risk it’s important to include fixed-income securities and other safe-haven asset classes in your asset allocation.
The good news is that you won’t have to go digging through the bond market to find individual bonds that will offset the risk of the equities within your portfolio. There are plenty of bond index funds that will give your portfolio some low-maintenance exposure to bonds.
As with stock index funds, all funds that track the bond market aren’t created equal. When looking into these funds, pay close attention to their expenses, historic performance, and income generated.
Final Word
All told, the index investing strategy is popular for several reasons. It’s simple to follow, capable of resulting in meaningful returns, and a low-cost approach to getting your feet wet on Wall Street.
However, like with any investment, strong research forms the foundation of your portfolio. While you won’t have to dive into each and every stock you’re invested in, it is a good idea to pay close attention to cost, historic returns, dividend yields, and the popularity of index funds before diving in. By doing so, you’ll give yourself a competitive advantage in the market.