Index funds take the guesswork out of investing, but you're by no means limited to them.
For some people, the idea of building an investment portfolio is overwhelmingly daunting. And if you're new to investing, or aren't well-versed in vetting stocks, that's understandable. Thankfully, there's a good solution for those who are nervous about hand-picking stocks, or for those who would simply rather take a more hands-off approaching to investing -- buying index funds.
Index funds are passively managed funds that aim to match the performance of the benchmarks they're associated with. If you buy S&P 500 index funds, for example, those funds will aim to do as well as the S&P 500 itself.
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There are many benefits to buying index funds and holding them for many years. But should they be your only investment? That depends.
A world of pros, but also, some cons
The great thing about index funds is that they take the guesswork out of investing. Rather than spend time researching different companies, you could instead load up on index funds in your portfolio and then effectively sit back and do nothing.
Index funds can also lend to instant diversification. And that's a good thing for your portfolio to have. It can help you weather stock market turbulence and set you up for long-term gains.
But index funds have their drawbacks, too. For one thing, when you buy index funds, you get no say in what they're comprised of.
Furthermore, index funds won't let you beat the broad market. If you're fine with the idea of matching the market's performance, then this isn't a problem. But if your goal is to outpace the market, index funds won't get you there.
And that leads back to our question -- should index funds be your only investment? Well, if you really don't like the idea of hand-picking stocks or are extremely worried about making a series of bad calls, then there's truly nothing wrong with relying solely on index funds to grow wealth over time.
On the other hand, if you're up to the challenging of choosing some of your own stocks, you can assemble a solid portfolio that consists partly of index funds and partly of the companies you identify as winners. That way, you get the relative stability and consistency of index funds, but you also get a chance to beat the market with the individual companies you land on.
If you're new to investing, you can absolutely start off by buying index funds alone as you learn more about how to choose the right stocks. But as your knowledge grows, you may want to branch out and add different companies to your portfolio that you feel align well with your personal risk tolerance and goals.
In fact, even if you reach the point where choosing stocks becomes second nature to you, you might still opt to hold onto index funds and add more to your portfolio. And if you have a 401(k) plan, which, unfortunately, generally won't let you invest in individual stocks, you should definitely consider loading up on index funds to avoid the heftier fees that tend to come with other employer retirement plan investments.
FAQs
The Bottom Line. Index funds are a popular choice for investors seeking low-cost, diversified, and passive investments that happen to outperform many higher-fee, actively traded funds.
How much of my investments should be in index funds? ›
The 90/10 rule in investing is a comment made by Warren Buffett regarding asset allocation. The rule stipulates investing 90% of one's investment capital toward low-cost stock-based index funds and the remainder 10% to short-term government bonds.
Should I invest in single stocks or index funds? ›
Index funds often have lower fees than the costs incurred when trading individual stocks. If you are hiring a registered investment advisor for investing in stock individually it may cost you much more than investing in an index fund.
Is an index fund enough? ›
If you're looking to make a long-term investment, then index funds may be a good option. But if you don't have the time or patience to wait out the market fluctuations, then purchasing individual stocks might be more suitable for your needs.
What are 2 cons to investing in index funds? ›
Disadvantages of Index Investing
- Lack of downside protection: There is no floor to losses.
- No choice in the index fund's composition: Cannot add or remove any holdings.
- Can't beat the market: Can only achieve market returns (generally)
Exchange-traded funds (ETFs) and index funds are similar in many ways but ETFs are considered to be more convenient to enter or exit. They can be traded more easily than index funds and traditional mutual funds, similar to how common stocks are traded on a stock exchange.
What is the 4% rule for index funds? ›
The 4% rule entails withdrawing up to 4% of your retirement in the first year, and subsequently withdrawing based on inflation. Some risks of the 4% rule include whims of the market, life expectancy, and changing tax rates. The rule may not hold up today, and other withdrawal strategies may work better for your needs.
Is it smart to put all your money in an index fund? ›
Index funds often perform better than actively managed funds over the long-term. Index funds are less expensive than actively managed funds. Index funds typically carry less risk than individual stocks.
What did Warren Buffett tell his wife to invest in? ›
In the interview, he said the Berkshire shares would go to philanthropy. Part of the cash would go directly to his wife and part to a trustee. He told the trustee to put 10% of the cash in short-term government bonds and 90% in a low-cost S&P 500 index fund.
Is it better to invest in multiple index funds or just one? ›
Some index funds provide exposure to thousands of securities in a single fund, which helps lower your overall risk through broad diversification. By investing in several index funds tracking different indexes you can built a portfolio that matches your desired asset allocation.
If you're buying a stock index fund or almost any broadly diversified stock fund such as one based on the S&P 500, it can be a good time to buy if you're prepared to hold it for the long term. That's because the market tends to rise over time, as the economy grows and corporate profits increase.
Why is ETF not a good investment? ›
ETFs are subject to market fluctuation and the risks of their underlying investments. ETFs are subject to management fees and other expenses. Unlike mutual funds, ETF shares are bought and sold at market price, which may be higher or lower than their NAV, and are not individually redeemed from the fund.
Is it okay to only invest in index funds? ›
If you're new to investing, you can absolutely start off by buying index funds alone as you learn more about how to choose the right stocks. But as your knowledge grows, you may want to branch out and add different companies to your portfolio that you feel align well with your personal risk tolerance and goals.
Do billionaires invest in index funds? ›
The bottom line is that even billionaires recognize the wealth-creation potential of low-cost index funds. Even if you're an active investor in individual stocks -- like Buffett and Dalio are -- rock-solid index funds like these four can help form an excellent backbone for your portfolio.
How long should you stay in an index fund? ›
Ideally, you should stay invested in equity index funds for the long run, i.e., at least 7 years. That is because investing in any equity instrument for the short-term is fraught with risks. And as we saw, the chances of getting positive returns improve when you give time to your investments.
Should I just put my money in an index fund? ›
Over the long term, index funds have generally outperformed other types of mutual funds. Other benefits of index funds include low fees, tax advantages (they generate less taxable income), and low risk (since they're highly diversified).
Why doesn't everyone just invest in the S&P 500? ›
The S&P 500 is all US-domiciled companies that over the last ~40 years have accounted for ~50% of all global stocks. By just owning the S&P 500 you miss out on almost half of the global opportunity set which is another ~10,000 public companies.
How long should I invest in index funds? ›
Index funds are recommended to investors with an investment horizon of 7 years or more. It has been observed that these funds experience fluctuations in the short-term but it averages out over a longer term. With an investment window of at least seven years, you can expect to earn returns in the range of 10-12%.
