Investing in Index Funds & ETFs
There are 4 types of investments that are great for beginner investors:
What is a market index?
A market index is a list of different stocks that all have something in common. This could be stocks from the same sector (technology), or country (United States).
Market indices help provide you with a ‘snapshot’ of the market as a whole.
Two of the most popular market indices are:
The Dow Jones Industrial Average (DJIA)
The DJIA tracks 30 of the most actively traded companies on stock exchanges in the US. It is one of the most watched stock index in the world. The list rarely changes and is capped at 30 companies. The DJIA is a good representation of the U.S. market and economy as a whole.
The DJIA uses a price-weighted method, so companies with higher stock prices hold a larger weighting.
The Standard and Poor’s 500 (S&P 500)
The S&P 500 Index is a list of the 500 largest companies in the United States. It’s regarded as the most diversified index and the best gauge of U.S. 'large-cap' companies. 'Large cap' is defined as companies with a valuation of $10 billion or more.
The S&P 500 uses a market-capitalization-weighted method. Market capitalization (cap) represents the value of a publicly-traded company.
So in the S&P 500, higher-value companies will hold a larger weighting in the index, which is shown as a percentage.
Investing in market indices
It is not possible to invest directly into the DJIA or the S&P 500. Instead, there are two options:
- Invest in the individual companies. However, you'd be more likely to invest in a handful, rather than the full 500.
- Invest in an index mutual fund or ETF. These funds track companies in the DIJA or S&P 500. Investors can invest in a basket of stocks through one transaction.
So instead of purchasing 500 individual stocks, you can invest in one index fund or ETF.
Index Mutual Funds
An index fund is a type of mutual fund. It aims to track the performance of a specific index.
Unlike other mutual funds, index funds tend not to be actively managed. Instead, a computer-generated algorithm tracks the best-performing stocks in the index.
Index Exchange-Traded Funds (ETFs)
Index ETFs work similarly to index mutual funds. Allowing you to take a passive approach to investing, tracking market indices.
The main difference between the two is that ETFs trade like shares on a stock exchange.
Benefits of investing in index funds or ETFs
Investing in a basket of stocks is a great and easy way to diversify your portfolio. Diversification helps reduce risk in investing.
Almost entirely automated
Automation helps take the emotion out of investing. Meaning that facts and data drive decisions, not feelings.
The automated nature of these funds means that there are fewer associated costs.
With all mutual funds, your involvement as an investor is very small. You decide how much you want to invest and for how long. You don’t have to make any of the tricky decisions, like what to invest in.
Negatives of investing in index funds or ETFs
Index funds and ETFs aim to match the markets, instead of beating them. Both of these investments are considered conservative, long-term strategies. They won’t make you a lot of money in a short period of time.
Like mutual funds, you don’t have control over the companies you invest in.
Limited to one type of stock
These funds will focus on one index, and that index will usually focus on one type of stock. Think large-cap stocks or American stocks. So your portfolio may still need further diversification beyond the index.