Have you been curious about index investing? It's one of the more popular concepts currently making the rounds of the financial community. Index funds track the overall return of a basket of stocks. So, if you are interested in the tech sector, for instance, and think it will do well, you can purchase a tech-index fund. That way, you're able to track the entire sector without having to pick and choose among individual companies.
People have been investing this way for decades, but only recently has there been an explosion of different types of funds for the various indices. The choices are virtually endless. For instance, you can choose from Dow, S&P, metals, healthcare, total global market, regional world markets, mining, retail, and pretty much every piece of any market or the entire market. Here are some of the main pros and cons of index funds.
Because you're not putting your money into one or two companies' shares, you get built-in protection when you choose a fund that is indexed. There's safety in diverse portfolios, and that same principle applies here. In a way, when you purchase a broad-based fund, you're instantly diversifying. That brings all the advantages of diversification, the main one being protection against volatility.
Expense ratios and fees associated with index trading are much lower than for any other kind of fund. Plus, if you tried to buy dozens of securities separately, you'd either incur pricy commission charges or drive yourself crazy trying to track each stock on a day-by-day basis.
There's Virtually No Upside
With the positive side of safety, security, and diversification you get one small negative. That's a low probability of large returns. Say you own 100 shares of XYZ Corp. stock, a medical research company, and they announce a breakthrough cure for a deadly disease. Those 100 shares could deliver a rather large profit in a very short period of time. On the other hand, if you owned 100 shares of say a medical index fund of which XYZ is a component, it's possible that you could miss out on any of the upside. Your fund shares might include 50 other medical research companies that didn't announce breakthrough cures.
You're Participating in Many Things at Once
Indexed investing means you're participating in a broad-based basket of stocks, sometime the entire economy. This can be a pro or con depending how you look at it. You get security, stability, and the chance to earn a profit in the long-term. On the downside, you won't earn outsize profits regardless of how well one or two of the component companies do. But, the idea of participating in a very large piece of the market is quite attractive to some investors. That's obvious from the billions of dollars that flow into the indexing segment every day.
The Boredom Factor is High
If you're the type of person who prefers day or swing trading, owning a basket of securities will probably be boring for you. But the conservative qualities of the funds make them ideal choices for anyone who wants to trade them with CFDs (contracts for difference) and thus minimize their risk.