Sunday, March 8, 2009

What is an index fund?

As i have mentioned several time on this blog, investing is the key to increase wealth.
One of the instruments available to the investor is the index fund. Today we will learn what is an index fund and what are the advantages and disadvantages of investing in an index fund.

We first have to look at the two types of strategies that an investor can choose.

1. Active investing

The active investor will trade often and would try to time the market. He would buy low and sell high. He would most likely spend a lot of time doing research. This strategy however is costly because you have to pay a lot of fees, so unless you are good at it you will rarely beat the market. Instead fees will eat in your return and reduce it. More often you will miss the lows and also miss the high.

2. Passive investing

The passive investor trade as little as possible. Time is his ally. He knows that on the long run the stock market rises and that if he buys for the long run and sell rarely his wealth will increase with time. So he make research and once he thinks that he has spotted a company that has value, he buy its shares.

An index fund is a mutual fund that try to mimic the stock market or a particular index. The company will buy shares in all the companies in the stock market or in a typical index. For example an s&p index fund will be composed of shares of all 500 companies in the exact proportion as their market capitalization. The index fund will thus increase and decrease in value just as the s&p. And since we know that the stock market always go up in the long run, then those that buy into index fund are certain that their portfolio will not fall in value or at least if the stock market fall, their portfolio will not perform badly. Such an investor knows that it is futile to try to beat the market. They thus move with it either up or down.

Index funds offers a lot of advantages. Normally when you buy shares you have to pay commissions and fees. So building a portfolio is quite expensive. When you buy into index funds you are buying all your shares in all the companies at one go, so it is really cheaper. One of the greatest costs in investing is the fees that you have to pay every time you buy or sell stocks. With time, if done often, it reduces your return.

So if you are entering the world of investing, index funds are a good choice. Your portfolio would increase in value with time, you would not make mistakes and lose your investments and more importantly no research, you will just sit back and enjoy life while your wealth increase.

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