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If you have always wanted to invest in the stock market but were unsure how to begin, there is an easy option to get you started; index funds. All the stock picking and asset allocation will be done for you. You sit back and watch your money grow. This is called passive trading or passive investment. By investing in an index fund, you leave the day to day movement to the market itself.
If you are wondering what exactly an index fund is, it is simply a group of stocks put together that keeps pace with the market as a whole. The fund manager buys and sells stock checking the equilibrium periodically. Basically you own a portfolio of assets, usually stocks and bonds, or more accurately, a piece of the portfolio without having to spend your time researching, buying and selling.
An index fund is actually a mutual fund that holds a consistent portfolio that does not change or trade with the fluctuations of the market. There are thousands of these types of funds offered so you may not be completely free from researching. An important factor to consider when choosing your fund is fees. This is an area that needs your due diligence. After all, you do not want to spend your earnings on them if you do not have to. Fees come in all sizes and speeds. Know what they are beforehand.
The main question to consider when looking to invest in a fund is your risk capacity. One of the advantages of this type of investment is its low-risk factor. If that is your investment strategy, you have many to choose from. If you would like a little more excitement in your investment strategy, with a possible higher return, but still wish to remain in the relatively safe zone of an index that too is available.
There are three common methods of indexing. The traditional method is, as stated, is owning a group of securities in a target index. It consistently collects said securities and only changes when a company leaves the target index.
Synthetic indexing involves the use of a combination of stocks and bonds. This allows for a higher possible return, albeit, with higher costs. The bond holdings can yield higher returns but also higher risks.
Enhanced indexing is a higher return, higher risk fund that involves a more active management. It is managed with specific strategies in both timing and rules that offset tracking errors from transaction costs. And enhanced index funds gain advantage by strategic positioning.
The reason these funds are cost effective is because there is no expensive analysis or pricey brokers. It is simplicity itself. Managing the fund only requires re-balancing a couple times a year. Because they are a passive investment, the gains are lower than an actively managed fund. This return can be significant. An investor in an index fund may keep only forty-seven percent of the return while a mutual fund actively managed will yield eighty-seven percent returns after sixteen years.
You may have heard the term asset allocation. That is simply the mix of stocks to bonds and other assets to match with the type of investment strategy planned. Factors such as ability to withstand risk, time-range and net worth all determine how assets are allocated. A fund can be designed for low costs and fewer taxes. There are combinations from high to low risk, for all types of investors. Generally speaking, the older you are, the less risk you should take. Younger investors have time to make up losses that might be incurred.
Index funds do not try to outperform the market. They merely keep pace and produce the same rate of return as the index. A fund that includes a greater number of securities has an overall better diversification than a fund with smaller numbers of securities. This diversification reduces volatility. A 5000-index would be considered less risky than a smaller specified fund that deals in one sector of the market such as a tech fund or energy fund.
Some funds are invested in only large companies which mean fewer companies, such as the S&P 500. Fewer holdings make for more volatility even if they are blue chip holdings. This is the most famous fund but there are a vast number of choices today.
The idea of an index fund was based on the analysis of one man who studied stock returns seventy-eight years ago. He determined that pure chance had as good a shot at returns as analytical stock picking. That it averaged out equally. This did little to kill the speculative element in stock investing but the index was born as a passive investment tool without fuss or fanfare. Those with keen gambling instincts should look elsewhere; there is plenty of roller-coaster investing to keep the most high-adrenaline-prone investor on his or her toes.
