You may have heard of the Dow Jones Industrial Average, the NASDAQ, or the S&P 500. These are called stock market indices, and they measure the U.S. economy’s health and performance through the stock market. As the American economy thrives, so do these indices. As the economy heads into downturn, so does the stock market, and thus, the indices. Have you ever wondered whether you could buy these indices? In fact, you can, through a type of asset class called an index fund. In this way, you can effectively buy into the broader economy – for any country, or even market sector.
What are index funds?
In the most simple sense, an index fund invests in a market basket of stocks and other equities. This “basket” can be comprised of anything, really, but generally the basket has a theme. There are index funds for Chinese stocks, index funds for only tech stocks, or index funds for retail stocks. For nearly any investing strategy, there is likely to be an available index or exchange-traded fund available to invest in.
There are many investment companies that provide different index funds. If you are familiar with the market, you likely know of Vanguard, VALIC, and Fidelity Investments, just to name a few. These companies have fund managers to manage these mutual funds. However, such funds often come at a cost. There is typically an “annual expense ratio” that must paid, though these fees are usually very small and negligible to the everyday retail investor.
The S&P 500 has its own index fund, ticker symbol SPY, or the SPDR S&P 500 ETF (exchange-traded fund). This fund’s goal, according to the State Street SPDR site, is to “correspond generally to the price and yield performance of the S&P 500® Index.” Thus, this ETF has the same market basket of stocks that the S&P 500 has. The price movements of the S&P 500 will be reflected in your portfolio, through SPY.
Investing in America
On CNBC last week, Buffet stated that $10,000 invested in 1942, would become $51 million today from the S&P 500 index. This is clear confidence in the American economy. Just as I described before, index funds track different baskets of stocks and investments. Thus, given the SPY’s tracking of American equities, investing in the fund would be justified under the prospect of a growing American economy. Buffet has long supported the usage of index funds, as the are low cost and they give you exposure to a variety of industries that support the American economy.
Index funds provide excellent exposure to a diversified portfolio (read more as to why this is important in Albert Lam’s lesson). For the everyday investor, lacking experience or knowledge with the stock market, such index funds are excellent purchases. The American economy is one of the strongest in the world, and should continue to grow at healthy rates, as well as continue to dominate global markets for decades to come. The index fund will most likely provide you much better returns than those you would receive from a savings account in a bank.
As a result of the large, diversified portfolio of most index funds, returns will be slow and steady. On good days, these indexes will increase anywhere from 0.7 to 1%, as the stock market tends to grow. These returns are much lower than those associated with technology stocks, or growth stocks. You are effectively limited in your choices with index funds – you cannot buy a certain industry or sector, and the vast array of investments will keep your returns limited.
This problem can be avoided by doing research on various companies, and comprising your portfolio with stocks that have high potential and lower risk. These are hard to find – which is why many simply choose index funds. However, if you can find the stocks that will have a great return on their price, leagues above the returns from the stock market as a whole, you have the potential to make much more money.
The problem of lower returns can also be fixed through riskier index funds – examples of this would be TQQQ, a triple leveraged ETF that tracks the NASDAQ. This would be an example of having a bullish sentiment towards the American economy, but if the economy does poorly, your losses will be amplified as well.
The reality is that not everybody has time to do extensive market research on companies. Doing the work – researching fundamentals, exploring company management, and determining of company products will maintain a dominant industry share – is difficult and incredibly time-consuming. Additionally, portfolios have to be managed and constantly supervised – if the company has earnings soon, or if a top executive has been fired, you may have to adjust your holdings. For these reasons, parking your money in index funds could be lucrative, and requires much less time.