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Warren Buffett, one of the most successful investors in the world, touted index funds as the best way for the average investor to generate wealth.
Although index funds have many advantages, some investors may find that this type of investment does not meet their needs. There are a few reasons why you should consider index funds, but also a few reasons why they may not be the best investment for you.
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Why invest in index funds
1. They create instant diversification
An index fund tracks a stock market index, such as S&P 500 or the Dow Jones Industrial Average. This means that these funds generally own all of the stocks in these indices.
When you invest in hundreds or thousands of stocks at a time, your portfolio is much more diversified than if you invested in a handful of individual stocks. If you invest in 10 different stocks and one of them isn’t performing well, it could have a dramatic effect on your portfolio. But if you invest in an index fund that contains 500 stocks, an underperforming stock won’t have as much of an impact.
2. They are more likely to rebound from market downturns
There are many types of index funds. Some are niche funds that follow smaller sectors of the market, while others are broad market funds that mirror major market indices, such as the S&P 500. A major advantage of broad market funds is that they are more likely to recover from market downturns.
The S&P 500 has been around for almost a century, and during that time it has seen countless large-scale fixes, slowdowns, and crashes. However, he still bounced back stronger than ever after each. While there is no way to know for sure what the market will do in the future, history shows us that if the market collapses again, the S&P 500 will most likely recover. And when your index funds mirror the S&P 500, that means your investments will rebound too.
3. They are cheaper than other types of investments
Index funds are passive investments, which means that no portfolio manager chooses which stocks to include in the fund. They just follow the indices, so that they automatically include all stocks in the index.
Compared to actively managed mutual funds, index funds tend to be less expensive. In actively managed funds, someone chooses which stocks to include in the fund, resulting in higher fees.
In theory, actively managed funds should earn higher returns than passive funds because an expert is deliberately trying to improve the performance of the fund. However, in 2019, only 29% of actively managed U.S. equity funds outperformed their benchmarks, according to a Morningstar study. So not only are index funds less expensive than actively managed funds, they also tend to perform better.
Why not invest in index funds
1. They can’t beat the market
Index funds have their advantages, but one of their biggest drawbacks is that they cannot beat the market.
By definition, index funds are just average. They are designed for to follow the market, so they can’t beat the market. For many investors, this is not necessarily a bad thing. Index funds may only have average returns, but their low costs and limited risks always make them an attractive option.
However, if you are looking to maximize the return on your investments and beat the market, index funds may not be the right choice for you. Instead, you can opt to invest in individual stocks. This option carries more risk, but the potential rewards are also greater.
2. You must invest in all the companies in the index
Another downside to index funds is that they don’t offer a lot of flexibility. Since index funds follow certain indices, you have no choice but to which companies you invest in. If a company is included in the index that your fund tracks, you should invest in it.
Again, this is not necessarily a bad thing. But if there are some companies that you would rather avoid, you don’t get that option with index funds. You will either need to invest in all of the companies in the index fund or avoid that fund altogether.
By investing in individual stocks, you have better control over your portfolio. Finding each individual stock you invest in involves a lot more work, but you also have a lot more flexibility than with index funds.
Maximize your investments
Index funds can be incredibly powerful, and choosing this type of investment has many advantages. But if you’re impatient to take a more hands-on investing approach, this might not be the best investment for you. By doing your research before you invest, you can make sure you choose the best option for your situation.
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