Index funds are mutual funds that are designed to track the performance of a particular index, such as the Dow Jones Industrial Average or the Russell 2000. Although you can buy the individual stocks that are listed on these indices, there are many advantages to investing in index funds.
An index fund contains the same securities as the index that it is tied to. Consequently, index funds require minimal management when compared with other types of mutual funds: fund managers do not have to make trading decisions. Passive management results in minimal operating fees and expenses for investors. In contrast, you typically have to pay a per-transaction fee when you buy individual securities. Beyond transaction fees, brokers often charge account management fees. You can reduce costs by trading your own stocks through a discount broker but even discount brokers charge trade and maintenance fees.
When you buy shares in an index fund, your only involvement in managing the investment occurs when you buy your shares, sell your shares or when you occasionally check your account balance. Portfolios containing individual stocks require more of a time commitment. You need to keep an eye on your various holdings so you can make investment decisions. Even if you employ a broker, you still have to set aside time to discuss your investment strategy with your broker and to give your consent to execute trades. If you buy stocks through a discount broker, you alone are responsible for managing the entire account.
When a corporation goes bankrupt, its stocks become worthless. Stockholders also stand to lose a lot of money when a firm experiences a financial downturn even if it technically remains solvent. You can mitigate the risk of a financial meltdown by investing your cash in a wide variety of stocks and securities. However, it can prove expensive and time-consuming to buy stocks in hundreds of different firms. When you buy an index fund, your holdings are immediately invested in a diverse range of stocks. The Standard and Poor's 500 alone contains stocks from 500 different companies. Even if 10 percent of the firms on the index were to struggle, you still have some of your cash invested in 450 other firms.
Some major corporations disburse company profits to investors in the form of dividends. Depending on your stake in a particular firm, your dividend checks may amount to anything from a few cents to several thousand dollars. Keeping track of dividends from multiple firms and reporting the income on your taxes can prove time-consuming. You can simplify your record-keeping and taxes by investing in an index fund. The fund itself receives dividends on the underlying securities and if you choose to receive rather than reinvest your dividends, these are passed on to you in the form of a single dividend check.
- Stock quotes image by Chad McDermott from Fotolia.com