There are many different approaches to investing. A popular avenue that many investors take is to invest in indices. However, it’s important to familiarise yourself with the pros and cons before taking the plunge, while ensuring that you’re using a reliable and versatile platform for index trading.
Here’s what you need to know.
How do index funds work
So, how do index funds work? An index fund is created to match the composition of a benchmark stock index and reflect its performance.
Examples of stock indexes include:
- S&P 500
- Nasdaq Composite
These two in particular collections of stocks are large and are regularly used by investors to track the performance of the equity market. The S&P 500 is the most popular index to track and has an annual return of 10%. You can easily access news updates about this particular index too.
Index investing counts as passive investing where a buy-and-hold strategy is used over a long period. It differs to active investing which involves regular buying and selling and is far higher maintenance.
Pros of investing in indices
Diversification is a well-thought-of approach when investing and the large array of stocks in indices diversifies away the risk you would be exposed to if you were to invest in a single firm. Investing in indices also eliminates the need to research individual stocks and decide how to spread your investments, though it is recommended that you research different indices before deciding which ones you want to go with. Imitating an index at an individual level would be tricky and time-consuming.
With this in mind, index investing is viewed as a convenient option by many traders and investors. A low-index fund especially is viewed as a sensible equity investment, making it a great all-rounder. You won’t have to build a portfolio from scratch this way as it gives you a good head start. If you find building financial knowledge draining, indices take away this burden.
Finally, indices have lower management fees compared to actively managed funds, which can make them a more accessible option for many traders.
Cons of investing in indices
As with any type of investing, it’s important to familiarise yourself with the cons, as well as the pros. This way, you can craft your strategy with care, factoring in any risks that could arise.
Loss of capital is a very real risk, which is why you should only invest what you feel comfortable with while implementing risk management strategies. Potential losses tend to be dictated by your risk tolerance – if you have a high-risk tolerance, you could expose yourself to significant losses. Remember, there is no limit to losses.
When investing in index funds specifically, you also don’t get a choice in the index fund’s composition, so you can’t tailor the selection in any way. You should also keep in mind that you can’t beat the market – however, you can achieve market returns on most occasions.