Index Funds for Dummies: Beginner’s Guide

Investing can be a daunting task! If you are annoyed by daily market ups and downs as a beginner, I will show you how to make index fund investing successful.

Index fund investing is a suitable fit for dummies or newbies. It provides a hassle-free solution for you to focus more on other essential things in your life. 

In the following, I will explain what you should know about index funds: 

  • the nature and mechanism of index funds
  • the pros and cons of index fund investing
  • how to identify and choose a good index fund; d. finally, I will show you where to find sources on index fund investing.

What is an Index Fund?

An index fund is a pool of funds to build a portfolio of assets by mimicking market indexes’ composition. Let’s take an example of some well-known indexes like the S&P 500 index and Nasdaq composite index.

A manager of an index fund regularly buys and adjusts stocks based on the components of an index, e.g., the S&P 500, according to the combinations of securities in the index.

It is an easy, passive, and no-brainer investment tool for a newbie investor without requiring too many deliberations. In other words: if you invest in the S&P 500 index fund, you have already invested in the most giant 500 corporations in the US. Just imagine how comprehensive your investing plan is!

Major types of indexes for index funds

The famous investing guru, Mr. Warren Buffett, encourages people to invest in index funds regularly and claims it is a safe bet for most people. The late John Bogle, the founder of Vanguard funds – one of the largest index funds in the US, says index fund investing is the most transparent to investors. 

Currently, there are various sorts of index funds available for investors. They include:

  • Nasdaq Composite made up of 3000 stocks listed on the Nasdaq exchange.
  • Dow Jones Industrial Average (DJIA), consisting of the 30 largest blue-chip companies.
  • Bond index: Bloomberg Barclays US Aggregate Bond index.
  • Russell 2000, comprised of US small-cap companies.
  • S&P 500, the largest 500 US companies, is listed on the New York Stock Exchange.
  • MSCI EAFE, consisting of foreign stocks from Europe, Australasia, and the Far East
  • Wilshire 5000 Total Market Index, the largest U.S. equities index

The investment scopes of index funds can even cover more like specialized industries, currencies, and commodities, but they are riskier for non-experts.

Are Index Funds ideal for dummies?

Index funds are a member of a family of mutual funds. They belong to passively managed pools of investments in the indexes and broadly represent movements of market changes. 

As a result of this, index funds have become popular among the general public. They are in use widely for different goals in sorts of stages in life, including:

  1. Retirement: you can buy it through your 401(K) or individual retirement account. You don’t always need to watch your portfolio because market changes reflect your portfolio’s.
  2. Education: shares of index funds are available for sale from mutual fund companies; therefore, you can buy them for your children’s education expenses.
  3. Wealth accumulation: If you want to save for future use or rainy days, you may consider buying index funds through a brokerage house.

Index funds are an easy-go managed tool for beginners if you are just a newbie or dummy in aiming for long-term investing.

How does the Index Fund Work?

As you know, an index fund is a pool of investments made by modeling on the securities of an index like the S&P 500 index. When you buy an index fund’s shares, you acquire all the stock holdings based on the index’s securities proportionally. 

Moreover, you can also purchase the funds share(e.g., SPY, QQQ) in business hours if listed on the stock market(New York Stock Exchange). 

Like a stockholder, you will get the dividends, interests, and capital gains regularly when the stocks or bonds pay. Even if the shares of an index fund are not listed on the stock exchange, you still can buy the securities based on the last working day’s price.

How to weigh index funds

As different combination methods calculate market indexes, index fund managers have to adjust the portfolios regularly and match an index’s weighting according to changes. The calculation methods of index mainly consist of 3 widely used sorts:

  • Price-weight index: This index takes the prices of the securities it holds into consideration. Securities of higher prices have a higher weight in the index. Dow Jones Industrial Average(DJIA) is the price-weight index. As the components’ prices determine an index’s weight, managers have to adjust the portfolios’ pricing to match the index weight accordingly.
  • Market-cap weight index: Each security’s market capitalization determines the weight of the index. Standard & Poor’s 500 index(S&P500). An asset’s high market cap has more impacts on the index, so has a market-cap weighted index fund. Managers have to adjust the changes in market cap changes in line with the index.
  • Equal weight index: It consists of equal proportions of securities in the index. S&P equal weight index(EWI) is one of the indexes. Managers do not change their portfolios frequently as the weighting is the same no matter the prices and market capitalization changes.

To recap, more rebalancing of portfolios is necessary for price-weight indexes, and vice-versa, least is for equal weight indexes.

Is an index fund investing passive investments?

Yes, it is! The actively managed fund has a goal of outranking the index; therefore, managers have to find market opportunities and determine strategies to manage their portfolios like buying, selling, and even hedging. 

However, it may incur more risks and expenses. In the long term, the strategy may not outperform the passively managed ones.

What are the Advantages of Index Funds

  • Long Term Performance: According to SPIVA statistics and Reports(SPIVA), almost 70% OF US large-cap companies cannot beat S&P Dow Jones Indices over the past five years until the end of December 2019. Even only one-third of mid-cap companies beat Standard & Poor’s 500(S&P 500) in one year. 

If we look further, only 13% of actively managed funds outperform the S&P Midcap 400 growth index over the ten years, according to investor’s business dailies. Advocates argue that few people can beat benchmark indexes; most of the wins are probably due to costs and lucks. Index funds invest based on the market indexes; therefore, they can generate better returns.

  • Lower costs: Index funds incur fewer costs than actively managed funds: 

1. Operating costs: trading costs are less because fewer trading activities occur, research and analysis(R&D) are almost zero as the components of index funds are in line with indexes.

2. Taxes: taxes related to trading and capital gains are less than actively managed funds. 3. Administration cost: Actively managed funds hold a larger staff than index funds and consume more expenses. They charge 0.75% to 1% more than index funds typically.

  • Transparency: Index fund components are reflective of that of the benchmark index. Expense allocations are clear and straightforward, and investment strategies are passive by copying the index ones. It is easy to understand how index funds work and what the fees are all about. If a beginner or dummy is mindful of complicated investing, he will most likely like the mechanism of index fund investing.
  • Diversification: Most index funds invest in major US indexes. The Dow Jones Industrial Average(DJIA) indexes and Standard & Poor’s 500(S&P 500) cover mainly blue-chip companies and various economic sectors and are nearly representative of the US economy. If you invest in the indexes, you invest in almost all sorts of sectors of the economy. 

The benefits: by investing in cross-section investing, you can reduce the risks of investing in only one industry and one company. That means: if you only invest in one sector or one company like textile manufacturing, you may suffer the loss as to the decline of the apparel industry, etc. 

In other words, you may not lose your bets by only investing if it suffers from a loss like Enron or Worldcom. Diversification means more protection to the index fund investors, especially to the new investors.

What are the Disadvantages of Index Funds

  • Lack of flexibility: As the name implies, index funds cannot invest more than it allows beyond the securities specified. Investors may miss other opportunities for returns. 

Moreover, managers have little discretion to change the portfolio’s combination by mimicking the index, which may lead to a loss of chances of profiting from the proportions of climbing stocks. 

For example, Tesla(TSLA) was recently added to the Standard & Poor’s 500; what if the security had been added to the index one year earlier or managers could buy the stock at will without any restrictions. The consequence: the returns for the index fund might become a different one!

  • Rarely outperform the index: Index funds are designed to model a benchmark index, so the intention is not to exceed an index’s returns.

If the market crashes, managers of the index funds can do little to stop them except sticking to an index’s components. They cannot sell to prevent the loss and buy more than specified to increase profit if the market climbs again. 

Moreover, index fund investors earn fewer returns than an original index delivers after paying expenses. However moderate the costs (depends on individual funds), the returns from index funds are mildly smaller than the market, and may contradict what ambitious and young investors intend to do!

  • Tracking error: Except for the above restrictions, index fund performance may vary from one to one even though all invest in the same index. 

The performance of respective managers is primarily attributed to the benchmark called tracking error. Managers have their discretion as to when to invest and create different prices for a stock. Consequently, a large index fund has more advantages of getting a favorable price for a stock than a smaller one. 

According to the benchmark index, a fund manager with a large cash flow may have a hard time converting the cash position into stock positions. Finally, not every index fund has the same tax position. It may likely affect an index fund’s performance! The benchmark error for passive index fund managers is a plus and minus 0.5%.

  • Management differences: There are no clear regulations for “index fund.” As the term index fund becomes more popular, index fund companies have their interpretations on naming and investing in an index fund regarding expenses and even portfolio combinations. 

Some index funds may seek active investment strategies to achieve returns above the index. This may increase the risks and easily confuse investors, especially beginners, under the umbrella of the name “index fund.”

How Should I Choose an Index Fund?

  • Risk tolerance: According to Investopedia, risk tolerance is a measure of the extent of investment loss an investor is willing to put up in the process of investing. 

Before investing, a financial planner will give investors options on what they can endure if their holdings crash, e.g., 25% or more: 

1. Sell all the holdings

2. Sell part of the holdings

3. Hold

The first one is conservative, then moderate; the final, aggressive. Risk tolerance differs on age, income, and attitude. A young investor may have high-risk tolerance with market swings relative to an aged one because he believes there is enough time to recover the loss. 

A high-income earner may endure more risks because he can earn it back in the future. An aggressive investor is more likely to bear more loss than a conservative one.

  • Fees: Charge fees by index fund companies varies to some extent. The annual expense ratio generally is 0.09% for stock Index funds and 0.07% for bond index funds.

An investor should look at the expense in detail; it affects the returns in the future. As to more charges, the longer one invests in index funds, the compounding effects of fees on returns will grow larger.

  • Time horizon: No wealth is created without time! Investing horizon makes a significant impact on everything about returns. The more time we let investments grow, the more returns we accumulate. Therefore, a reasonable investing period should be set up beforehand!

An investor should talk to his financial advisor before making any decision as to his investing goals. Besides, a financial advisor should regularly review changes related to risk tolerance. Investors should have their portfolios reviewed every half a year at least.

  • Index fund operating strategies: An investor should review the index fund operating policies before investing in an index fund. As said, some funds may allow managers to lend securities or cash to increase profits. 

The practice seems to increase the returns but also raise the risks to investors as well. A conservative investor should avoid this kind of index fund with this trading policy.

5 ways to identify a good index fund

  • A good index is transparent: A good index should consist of 2 significant factors: 

1. The purpose of the index.For example, the Standard & Poor’s 500 index is designed to measure the US’s top 500 companies’ performance and a capitalization-weighted index. Of those, most market-cap companies have a major impact on the combination of the index.

2. It should have breadth. Russell 3000 index consists of 3000 publicly listed companies in the US and covers almost 98% of the publicly traded market. Therefore, whether new or experienced, investors should clearly understand the indexes they will invest.

  • There is minimal turnover: As an investor, Imagine you encounter an ever-changing index and are aware it frequently changes components. 

As a result, the manager has to frequently rebalance the portfolio in line with the changes and increase the administrative and trading costs. 

Furthermore, the credibility of the index may be in question due to this inconsistency. It may become difficult for investors to track and follow. A trustworthy and highly authoritative index should include a stable and steady combination of components.

  • The index is logical: Better know-how helps you make better decisions! 

Let’s take an example–the stocks in the Standard & Poor’s 500 index are selected based on eight criteria: market capitalization; liquidity; domicile status; public float; global industry classification and standard of the industries in the economy of the US; financial viability; length of public trading time and exchange. The index is calculated based on a market capitalization method. 

The calculation is open and logically understandable. You may suffer a considerable loss if you make a wrongful decision based on misinformation and unclear grounds offered by an index fund.

  • The index is relevant to the real world: Investing is all about “invest for growth.” Growth is for the economy, industry, and enterprises. 

Think if you intend to invest in MARS, you may not currently see the growth potential because a method for index calculation is hardly justified and unpracticable. However, you are to feel confident in investing in companies contributing to industry and economic growth. 

That said, a reliable index must comprise:1. productive companies for real growth for investors; and 2. long-term nature for wealth accumulation. Indexes like DJIA, S&P 500, and Russell 3000 meet the above criteria.

Are Index Funds A Good Investment?

Markets are full of unknown factors! Whether you are an experienced investor or a dummy beginner, you may sometimes be caught up by sudden unexpected events within. 

There are some occasions when you may have to react panicky or hilarious even though you think you are well prepared. These kinds of Irrational behaviors can dominate your mindset and cause major loss to your investments.

Index funds provide a platform for new or experienced investors to follow and benefit from the corporation’s growth. The advantages are:

  1. you don’t need special knowledge to participate in the game
  2. You can participate in a wide range of investment tools and diversify the risks\
  3. As most investors cannot beat the market, index fund investors will let investors gain the rewards handsomely if you choose to invest in index funds wisely( I will tell you later in the following).
  4. Due to its low cost, simple mechanism, and transparency, index funds are appropriate tools for general investors, especially investing beginners.
  5. Finally, they are ideal vehicles for long term investors planning for children’s education, retirement, traveling, raining days purposes.

If you have a long-term investment concept, you should consider the benefits index funds will bring. Good preparations are the first step towards your financial goals. 

Closing 

Various kinds of index funds can make you dizzy as you have to spend a lot of time combing through the racks standing inside the fund houses. So, information gathering is the first-go task. 

Financial intelligence sources like TV: Bloomberg, Reuters; financial newspaper, e.g., Wall Street Journal, Financial Times; online magazines like Investoralist; Barron’s. They provide information and analysis relating to the index funds industry. 

Besides, Investoralist also provides in-depth knowledge and comparisons, so investing dummies and experienced investors should benefit before any happy investing!

Ezoicreport this ad
Subscribe to Our Newsletters​

Stay Up to Date on Investment News
Delivered to You