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Investing in your freedom (retirement) doesn't stop at a 401 k or Roth IRA. In addition you can take advantage of the various market indexes of index funds and invest more of your earnings for a successful retirement.
There are so many ways that you can use your earnings to invest in your freedom accounts (retirement) and even ways to start with a minimum investment. Index funds track the broader market and it's performance, so there are caveats to it. Let's talk about index funds and how they can help build your portfolio and retirement funds for the future.
What are index funds?
S&P stands for Standard & Poor, and it's essentially an index for the progress the market is making. It takes the top 500 companies in America and measures their performance within the market.
Essentially it's a mutual fund, or a way to pool your money with other investors to buy stocks, bonds, and other investments. Now, an important thing to note about index mutual funds, that is a benefit of the index mutual funds, is that these account for a large portion of the stock market so it's often referred to as a great gauge for how the overall stock market is doing and in turn, the economy.
Which companies are part of these mutual funds?
The mutual fund includes the largest 500 U.S. companies, and most of them you'll recognize immediately. These companies are placed on benchmark index based on their market capitalization, or the value of the company traded on the stock market. So those with larger market caps are "weighted" higher in the financial market.
There are 500 companies that are part of these funds, and you can find the full list here, but you will probably recognize the top 10 companies on this list. I'll touch on this later, but this is why index funds are a great way to automatically diversify your investment portfolio. This one type of investment gives you shares of over 500 companies, all in different financial markets.
The top 10 companies on this list are:
- Alphabet (class A)
- Meta Platforms
- Alphabet (class C)
- Berkshire Hathaway (class B)
- United health Group
The caveat with this list is if a company, Google for example, has more than one set of shares with a significant enough market cap, they can appear on the list twice. This is why Alphabet, parent of Google, is shown twice with two different classes of shares per market index - class A and class B.
What are index funds and how do index funds work?
Index funds are similar to that of investing in the stock market the traditional way, by buying and selling stocks based on performance and market timing - however, index funds are more passively managed. Essentially these "mutual funds" mimics the market as a whole and in turn their performance, this goes for both positive and negative performance of mutual fund.
Think of index as a category an index fund as the stocks that make up index mutual fund make up that category. There is an index and corresponding index fund for about every financial market that exists. Investing in index funds can be great for your Roth IRA or 401k portfolio as it often makes more sense, according to Warren Buffett, for the "average" investor to invest in an index fund rather than investing in the stock market in the traditional sense.
How is this different from stocks?
Index funds are different than stocks in the sense that instead of picking your stocks and then buying and selling by paying attention to the market, the index funds are a combination of the top 500 companies in the United States and there is no buying or selling involved.
With the stock market, there is a necessary aspect to pay attention to the market and how particular stocks are doing, in order to take full advantage and buy and sell when appropriate. Index funds are considered a passive investing process because this is avoided. Now, that being said, like anything, there are obviously pros and cons to investing in index funds.
Pros & cons for investing in index investments
While index funds are different from that traditional stock investing, there are people that may see great benefits to invest in index funds, while others may want to stick to traditional investing. No matter what you're preference, index fund investing has it's pros and cons, as with anything in finance. Let's take a look at them and get the full picture for how they differ from actively managed funds.
- Predictable compared to stocks: overall, index funds are generally predictable and because they "mirror the market" you tend to see what will happen when you invest, but returns are limited. This is why those that may be new to investing, or those that want a form of passive management, will find index funds fit for them.
- Diversified portfolio: another pro with index funds is they're automatically diversified, so no need to sweat ensuring your investment portfolios are diversified enough, because index funds are already there. They come with the top 500 American companies all in different industries creating a beautifully diversified portfolio without having to manage multiple traditional stock investments.
- Low administrative fees: this aspect is attractive because they don't have many fees associated with them, because they are passively managed index funds and mirror the market. The fact that these have a low expense ratio, attracts a lot of investors to index funds.
- Keep up with the market, but no major returns: in a way this can be a pro or a con depending on the type of investor you are, but generally it's viewed as a con to index fund investing. These follow and keep up with the market, but there are better ways to invest where you can get a bigger return and essentially beat the market.
- Passively managed funds: again, another one that can be seen as both a pro and a con. However, passively managed funds, as opposed to actively managed, meaning there is no professional-level management and it can add stress onto you because well, the management is your responsibility. Adding to that, they don't make big returns, so it's a lot of stress for little to no reward.
- Rigid and inflexible: the 500 companies that are part of an index fund only change if the S&P adds or drops companies from their list. So, unlike traditional stock marketing investing, these stay relatively the same and very rarely change what companies are included. Most investors appreciate the chance to invest in new and international companies, but with index funds that's a no-go.
- CAN be more expensive: when it comes to maintenance fee's, index funds can get more expensive with again, little to no return. There are other investments you can make with much higher returns and ways to grow your investments.
So, index funds still have their pros and cons, like any other form of investment. However, if it's right for you to purchase index funds, it may be a great way to have a well diversified portfolio in different financial markets, low expense ratios, and still be able to have a comfy retirement.
Index funds are mutual funds that "mirror" the market with diversified shares from the top 500 American companies. These are not actively managed funds, they are passive and because they tend to mirror the market index, they can be a great way to invest but also have their downsides. They have low expense ratios, but index funds investing doesn't allow you to take advantage of new or international companies because the particular index funds generally stay the same.
Among these index funds are top companies such as Apple, Amazon, Microsoft, and Tesla but again, they differ from actively managed funds like traditional stock investments because you do not need to keep an eye on the market in order to maximize your investment by buying and selling at the right time. It is a type of low-risk investing in index funds, but in turn there is little return and no possibility for large returns like in traditional stock investing.
Index fund shares typically have lower costs and allow you to automatically diversify funds invested based on the market's performance. Companies that are part of this represent a broader market and those with a large cap index are rated higher than those that don't, it can be a great form of wealth management and building when you're either new to investing or want something that's low risk.
All this being said, it's a great idea to talk to fund management specialists or your financial advisor to see what type of investment account will work best for you. Typically index funds have lower management fees because they are passive, but other index funds or forms of investment might be a better fit for your current financial situation and wealth management goals.