If you want to invest, but don't have time to choose individual stocks, indexing may be the way to go. By buying one index fund, you can own small bits of hundreds of companies.
Some investors want to beat the market. Their goal is to get higher returns on individual investments than what they could get by simply owning an index fund that tracks the same type of investments. So they trade actively, trying to own the right investments at the right time. Beating the market is a nice thing, if you can do it. But the truth is most investors can't.
The other approach is a strategy called indexing. With indexing you invest in a number of exchangetraded funds (ETFs) or mutual funds — or both. Each fund owns the same investments that are tracked by a specific market index. You buy the funds because you can't invest directly in an index. Nobody can. And, in any case, you probably don't want to individually own the 500 stocks in the S&P 500 or the 2000 in the Russell 2000.
To put indexing into practice, you gradually build a diversified portfolio of index funds, allocating some of your principal to stock indexes and some to bond indexes. As you begin, you might want to focus on a few well‐known indexes in each asset class that cover different segments of the market — large company stocks in the case of the S&P 500 and small‐company stocks in the case of the Russell 2000, for example. In most cases, you can reinvest your earnings to buy more shares.
As you invest more, you can branch out to smaller or more specialized sectors of the market or funds that track international indexes. Something to keep in mind is that narrower indexes may be less diversified and, in the case of ETFs, may be less liquid because they're traded less frequently.
Some advantages of indexing
One advantage of indexing is that it's less expensive to own index funds than actively managed funds because the expenses are typically lower. This is usually easier and cheaper than trying to create a well diversified portfolio of individual securities.
Another advantage is that index funds historically, over time, have shown higher average returns than actively managed funds that invest in similar securities. That's true in part because of their lower expenses. Remember though that fee structures vary among fund companies, and while several funds may track the same index, they won't have identical returns. Expenses are the culprit.
Finally, because an index fund makes changes to its portfolio only when the components of the index are changed, sometimes as infrequently as once a year, index mutual funds also tend to be more tax efficient than actively traded mutual funds.
And a disadvantage
One drawback of index investing is that in a down market, index returns are down too. There's no investment manager to shift focus to investments that are doing better than the pack. But even those down years, as depressing as they are, don't change the fact that index funds typically outperform active funds over the long haul.