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Understanding Index Funds

Lower costs & diversification. 

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Investing is a skill that some people develop over time. When just starting out, novice investors might not be comfortable choosing individual stocks. In these instances, options like index funds merit consideration.

Investopedia advises that an index fund is a type of mutual or exchange-traded fund (ETF) that tracks the performance of a market index like the S&P 500 or the Russell 2000. The index fund holds the same stocks or bonds as the index, or a representative sample of them. Some index funds track specific stock sectors, company sizes or additional qualifying parameters.

Index funds do not change very often, and will only do so when the makeup of the index they are tracking changes. Index funds are popular investment vehicles for many reasons. Here’s a look at why it can be advantageous to invest in index funds.

· Lower costs: Because index funds do not have fund managers who actively buy and sell assets regularly, they typically have lower fees in the form of expense ratios, which are the costs of running the fund.

· Passive investing: Index funds are a long-term strategy that utilizes passive investing so that an investor doesn’t have to pick securities or time their choices to the market.

· Diversification: Index funds enable investors to enjoy broad market exposure across various sectors and asset classes according to the benchmark indices they follow.

· Reduced bias or error: According to Fidelity, professional investment managers may make mistakes during stressful market conditions. Index funds don’t require a manager to make decisions beyond tracking the index.

· Reduced taxes: People who invest in actively managed funds that sell frequently tend to owe more taxes than investors in funds that sell less often. Index funds tend to not sell often.

Although there are many perks to index funds, there are some detriments as well. Some funds put a lower limit on how much an investor needs to invest. And while index funds are low-cost, they aren’t always no-cost. A fund’s expense ratio needs to be examined to ensure that the smallest cut of returns goes to the fund manager. Investors choosing index funds may earn a lower return than if they had chosen their own best-performing stocks. Index funds include both high- and low-performing stocks and bonds.

Index funds merit consideration by investors who want investment vehicles that are relatively easy to manage.