A stock index fund is becoming increasingly popular as investors seek investments that are a little easier to manage.
An index fund is designed to match the investment results of a specific market index. That said, it can consist of either stocks or bonds in its portfolio. The difference when comparing index funds is the tactics that they employ to achieve the desired returns.
Just like any other product in the market, an index fund has its pros and cons. If you still think that it’s a great tool that you can employ, then, by all means, go for an index fund because they are one of the simplest types of investments you can make.
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Pros
Less risk
The biggest advantage to choose an index fund over individual stocks is that they have a relatively low risk that is designed just for long-term growth. Intrinsically, they are already diversified enough with stakes in different sectors within an index. This really protects the investor against any big losses.
Low fees
The easy comparison is that index funds offer lower fees compared to non-index funds. This is important because when you have high fees, your returns must exceed the fees or you’ll be walking away with the same amount of money as you started.
Another reason for those higher fees from the non-index funds is that they are actively managed and have more transactions. When these small transactions are done multiple times, the fees can really add up.
Avoid market swings
Another reason why an index fund is geared towards long-term investors is that it removes a lot of short-term volatility. This short-term volatility will often be regarded as a mere correction in the market that will very likely recover eventually as markets generally balance over the long term.
In other words, that means passive investors can automate their investments each month and they are more than likely to be in profits over the long term.
Require less management
If you do not have much experience in the financial markets or do not have a lot of time to follow the financial news, index funds are perfect for you. Firstly, it’s because you’re not buying one single stock, therefore eliminating the risk of having any bad news affect your portfolio.
Secondly, you don’t have to learn to time the market. Just provide the money every single month and dollar-cost-average into the index fund of your choice and leave it. The market and compound interest will take care of you.
Related: The Ultimate Guide To ETF in Malaysia: How Do they work?
Good things take time
Cons
No exponential gains
An index fund does not have the potential to outperform the market in a way that actively managed funds can. That’s mostly owed to the fact that it is heavily diversified. So what it means is that you will be giving up the possibility of exponentially growing your portfolio.
It’s the same story as the Hare & the Tortoise. The Hare is an actively managed funds, the Tortoise is an index fund. Would you rather have ‘slow and steady wins the race’ or ‘take the risk and hope for a bigger reward?’
Lack of flexibility
Index funds are special in the sense that they must follow certain policies that help them perform in tandem with an index but that comes with the price of less flexibility compared to managed funds.
In periods where there is minimal volatility, there wouldn’t be much of an impact. But when the market is experiencing higher-than-normal volatility, managed funds trumps as they have the flexibility to profit from other options while index funds cannot.
Takes a long time
Although investing in individual stocks can be choppy and sometimes dangerous, but for professional investors, there is a much bigger profit potential than there is in an index fund. Finding good stocks is how an investor beat the market and get ahead in this game.
However, for an index fund, your returns are mostly on par with the overall market. That means your returns will most likely be under 10% annually. Don’t get me wrong, 10% is a very good number but understand that this is the best-case scenario as you might get lesser during economic downturns.
Unexpected concentration
It is a known fact that the market ebbs and flows. And following that is the fact that some sectors and industries will perform better than others. For example, the technology stocks in the US stock markets such as Apple, Google and Microsoft has greatly outperformed the average by a wide margin.
From another perspective, if a certain index fund is heavily concentrated on a certain sector, any huge news within this sector might cause the index fund to fluctuate.
Related: 7 Investment Lessons You Should Learn From Successful Investors
Final thoughts
Generally speaking, index funds are a great way to invest for the average proletariat as they offer good market exposure with minimal risks. Nonetheless, just like other investments, you have to know what you’re getting into first before diving in—the good and the bad. Any kind of investment involves risk, it’s a matter of what is more suitable for your situation.
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