This week our focus will be on another financial instrument to achieve diversification, index funds. As I spoke of last week, ETFs and Index Funds can be used to obtain diversification in an investment portfolio. It should be noted that Index Funds are actually a form of ETF, so many of the principles and mechanics from ETFs will carry over.

It can be assumed that most people have heard the phrase “the market is down today”. If you have heard of this before, you actually know what an index is perhaps without even realizing it.  

Whether someone is saying the market is down or up, they are typically referring to indexes such as the S&P 500, the NASDAQ Composite, or the Dow Jones Industrial Average.

The S&P 500 consists of the 500 largest companies in the US. As noted last week, larger companies are typically less volatile therefor safer investments.

The NASDAQ is an exchange as well as an index. On the index side of things, the NASDAQ Composite consists of about 3,000 companies listed on the NASDAQ exchange meaning not all are based in the US. In some market environments, this index can greatly outperform the others by a few basis points due to its exposure.

The Dow Jones is an index that consists of 30 large U.S. companies in different industries. This is my least favorite index as the 30 companies it consists of were added years ago and the composite rarely changes. This means fast-growing companies such as Amazon and Google are not included. This can also be looked at as a positive in the sense that the Dow has extremely stable companies such as Disney and McDonald’s meaning it is a “safer” investment.  

To acquire an index fund, it is done through an ETF that matches or “follows” the desired index.

It is good to own an Index Fund that “follows the market” due to the fact that in the long run the market always wins. Many active fund managers attempt to “beat the market”, but it has been proven time and time again that it is typical to get greater returns through an index fund rather than hiring an active manager.

It is hard for anyone to “beat the market” as there are simply too many variables. I like to follow the saying “If you can’t beat them, join them.” This saying applies in the investment context; it is best to buy an Index Fund oppose to actively managing a portfolio in the long run.

Another advantage to index funds aside from diversification and returns is the fee reduction. Instead of having to buy each individual stock apart of an index and having to pay a transaction fee or management fee, with an index fund there is one transaction fee and one small annual fee just like any other ETF.

One advantage to an index fund rather than just any ETF is the diversification achieved.  To achieve proper diversification with other ETFs more than three need to be purchased. With an index fund, an entire portfolio can consist of three or fewer index funds and it is considered on the safer or conservative side or investing.

DISCLAIMER: Cameron is not a certified financial advisor and all things stated should be considered solely as entertainment and NOT for financial transactions.