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Okay, so you want to start investing in index funds.
You already have a solid investing strategy you want to use, but you’re not sure how you feel.
You’ve heard stories about people losing money in the stock market and don’t want to go down the same path as them.
I’m here to tell you there’s nothing to worry about. Index funds are a safe place to stash your money. As long as you’re holding for the long term, your money will continue to make your more money.
Today, we’re going to dive into the four reasons why index funds are safe. Without further ado, let’s get started.
Index funds are safe because they’re diversified
The first reason why index funds are safe is that they’re diversified.
A single index fund consists of many different stocks. For example, an S&P 500 index fund carries over 500 stocks, and an international index fund like Fidelity’s FTIHX carries around 5,000.
Being invested in this many stocks adds diversification to your portfolio, and diversification reduces risk.
Why does diversification reduce risk, you ask?
Let’s say, for example, you think the technology sector is going to experience a boom shortly. You especially think that Tesla has a bright future ahead, so you invest a big chunk of your money in Tesla.
Investing a big chunk of your money in Tesla is taking on a big risk because if the company ever goes out of business, you would lose all your money.
However, if you were to invest in a tech sector index fund, you’d have your money spread among many different tech stocks. Although a couple of stocks go out of business, the index fund would remain afloat from the other businesses that are doing well and you wouldn’t lose all your money.
This makes index funds a much safer option when compared to individual stocks.
*How much money should you be investing each month to achieve financial freedom?
Index funds are safe because they’re passively managed
While actively-managed mutual funds actively try their best to beat the market average, index funds are passively managed which makes them a safer option.
Index funds are only required to match the performance of their benchmarks. Therefore, there’s little room for error and it’s much easier for the fund manager to manage the fund.
Did you know that more than 80% of actively-managed mutual funds fail to outperform the market average?
There are a couple of reasons why that happens.
First, actively-managed mutual funds are expensive. Nobody works for free, and neither do the fund managers. These fund managers charge a hefty expense ratio because attempting to outperform the market’s average requires years of expertise and experience.
The average expense ratio for actively-managed mutual funds hovers around 1%. This is extremely high and will eat into your profits (the average expense ratio for index funds is around 0.03%).
Second, human nature causes fund managers to buy and sell stocks at unfavorable prices. Let me explain how human nature gets in the way of investment profits.
First of all, money in the stock market is made by buying low and selling high. But that’s not what happens with most mutual funds.
Let’s say fund G has performed extraordinarily well throughout the past three months. The fund would gain publicity and more people would begin to buy in.
As more people begin to buy into the fund, this would force the fund manager to buy more stock at higher and higher prices.
On the other hand, if fund G performs poorly for months on end, people would begin to panic and sell to close their positions. This would cause the fund manager to sell at lower and lower prices.
Can you see how the exact opposite happens? It’s extremely difficult for an actively-managed mutual fund to consistently outperform the market because of compulsive buying.
Index funds are safe because of their low volatility
Index funds are safe because they’re less volatile compared to individual stocks.
An individual stock can drop 75% within six months. Take a look at Netflix (NFLX). After the pandemic, their revenue dropped significantly because people were no longer trapped in their houses.
However, the same doesn’t apply to index funds. Because an index fund is a basket full of different stocks, the index fund’s performance will reflect the average of all the stocks it holds.
Therefore, index funds usually don’t experience any volatile swings like individual stocks do.
This can be a huge pro for those who can’t stomach volatility. Some people can’t handle watching their portfolio go through volatile swings, so index funds would solve that problem.
One thing to remember is that any investment contains risks, and index funds are no exception. Investing in index funds doesn’t guarantee profits every year, but steady returns over the long term.
For example, the average return for the S&P 500 since its inception is around 10%.
Read More >> The pros and cons of index funds
Index funds are safe because of no permanent losses
Buying an S&P 500 index fund is like buying a portion of the U.S. economy.
The index fund contains around 500 of the largest companies in the United States, all from different sectors.
As long as the U.S. economy is doing well, the index fund will grow with the economy.
So before you invest in an index fund, the only question you have to ask yourself is, “do I believe in the overall performance of this sector or market?”
If you want to invest in an S&P 500 index fund, do you believe in the overall well-being of the U.S. economy?
If it’s a European index fund, do you believe in the overall health of the European economy?
If the answer is yes, then invest in the fund.
One thing to keep in mind is that the index fund will experience downturns and bear markets. Not every year will be profitable and you’re going to lose money.
However, losses in the stock market aren’t real until you sell. As long as you don’t sell to close your positions, they’re called “unrealized losses,” and they’re not permanent.
Because losses aren’t permanent until you sell, index funds are safe investments. As long as you’re holding for the long term, you’ll always be profitable.
Conclusion
Index funds are safe because they’re well-diversified, passively managed, and low-volatile investments. Historically, the market has proven to us that no matter how bad the recession is, it will always recover and reach new highs.
In contrast to popular myths, index funds are great for those who are looking for a hands-off approach to their investments.
Warren Buffett has said on multiple occasions that the majority of people would be best off if they were to simply invest in an index fund.
Hungry for more information? >> Read my free all-in-one guide for index fund investing!