- What index investing is
- Why investors use index investing
- How index investing can fit into your strategy
Have you ever spent 15, 20 minutes or more deciding what to order on your food delivery app? Or scrolled through hundreds of TV shows on a Saturday night realizing that you could’ve watched a full episode already with the time it’s taken you to decide? Having plenty of choices nowadays is a great privilege, but also creates challenges of picking the “right one”.
Investing is similar. There are thousands of investments to choose from, but that choice creates a challenge of figuring out which to research and invest in.
Index investing can be a great way to reduce that challenge while also providing a diversified range of investments in one fund.
What is index investing?
As the name says, it is investing in an index. But what is an index? You can think about an index as a calculated measurement of a market’s overall performance. The “market” typically refers to a collection of different companies that meet a certain criteria. For example, the S&P 500 is a market-capitalization-weighted index that measures the performance of the 500 largest publicly-traded companies traded in the United States. When you hear people talk about a certain market doing well, they’re typically referring to an index as a representation of the market’s overall performance.
Index investing uses a specific index as a model to create an index fund. These funds commonly come in the form of Index-ETFs (Exchange traded funds) which may contain (or a combination of) hundreds of different securities like stocks, bonds, and other types of investment. So even if “all your eggs are in one basket” with an index fund, that basket is itself diversified into hundreds stocks, bonds or other securities.
Why do some investors choose index investing?
There are three big reasons why investors invest in index funds: diversification, convenience, and lower fees.
The first is diversification. As we stated earlier, index funds are usually made up of many different investments, thereby spreading out what you are invested in. Typically we think of diversification as “if one stock isn’t performing well, the other stocks will help to balance it out.” In the case of index investing, when one stock isn’t performing well, the fund may have hundreds of other investments to balance it out.
The second factor is convenience. Imagine having to research, buy, and regularly rebalance 50-100 different stocks (or even 500) by yourself. With index funds and ETFs, you can hold 50-100 (or more) stocks in a fund that rebalances itself, and can be acquired with a single purchase.
Third is lower fees. Since index funds’ management is typically automated, the fees associated with index funds are typically lower.
How index investing can fit into your strategy
As an option to provide more diversification and convenience, investors typically think about index funds (ETFs) in the following ways:
Please note: The information prepared in this section is for educational purposes only, and should not be taken as any form of trading or investment advice.
Index ETFs in a stocks portfolio
While stocks can offer a higher potential for return, it could also come with higher volatility. The addition of index ETFs to a stock portfolio might offer lower volatility and increased diversification.
To give a hypothetical example, let’s say you’ve been investing in several stocks from different companies in the financial, communication services, and energy sectors. You can see some diversification here but if one (or more) of those companies decrease in value due to company-related risk, you might incur some losses. If you add an index ETF that spreads out to similar companies in the same sectors (or more), you can potentially guard your portfolio against such losses.
To get more diversification, some ETFs follow an international index. This can be an option if you’d like to invest in international companies in different sectors.
You may be the type of person who doesn’t always want to check their investments daily. You’re okay to buy stocks, bonds, and other investments and manage them a few times a year. Some people who fit this category might create an ETF portfolio which may include index and or other types of ETFs. This allows you to invest how you like, while providing broad diversification.
It is also a good practice to manage (or rebalance) your portfolio to ensure you’re investing within your risk tolerance and goals. The frequency for rebalancing depends from person to person. For more convenience, we have our partner Passiv that automates your investments. This helps track, rebalance, and send alerts for any changes in your portfolio.
Whether you’re researching for the “right stock” or simply looking to diversify more, index investing can be a great option. It may benefit your investment for its simpler approach, diversification, and lower fees.
Or if you haven’t started investing yet, you can start here to open an account!
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The information in this article is for information purposes only and should not be used or construed as financial or investment advice by any individual. Information obtained from third parties is believed to be reliable, but no representations or warranty, expressed or implied is made by Questrade Group of Companies, its affiliates or any other person to its accuracy.