An Index Fund is a portfolio of stock holdings that highly correlate with the index it is tracking. Learn about correlation here. Since an Index is a very stable grouping of stocks, it does not require much active management, and thus can be managed extremely cheaply.
Investors are then able to earn dividends and realize market returns with an extremely low management fee.
Most Index Funds do not directly charge investors with flat % of asset fees or fixed monthly fees. Instead, they sum all the assets and earnings for a year into one large pot, then take a percentage from that before dispursing the earnings back out to investors. This 'fee' is called the Expense Ratio. Since this ratio will be deducted from the fund's annual returns, it is important to keep this in mind when comparing Index Funds.
Some very common Index Funds and respective Expense Ratios are:
As you can see, the expense ratios for these Index Funds are much lower than a 'standard' Financial Adviser, however, they do vary.
The Vanguard S&P500 fund is the cheapest Index Fund I've seen and is the best option for American investors looking to get started with investing or wanting a lower-risk way to hold a position in the market.
You can invest in any of these ETF's through your brokerage. Of course, we recommend Robinhood, as it has the lowest costs!
As you begin your search, ensure to consider the expense ratio.
You may have heard about diversification. Index Funds are a good way to diversify, however, most stocks in the S&P 500, for example, correlate with each other. Thus, if a large US recession occurs, this index fund will perform poorly. It is important to diversify your investments in funds that do not correlate. This will mitigate your risk and earn the largest risk-adjusted returns. To learn more about correlations and access the link to our free correlation calculator, click here.
The final point on Index Funds is taxes. Holding an investment for longer than 1 year deems that investment a long-term investment. Long-term investments are taxed at a 15% rate. If you sell your investment before the 1 year mark, your earnings will be taxed at a 30% rate. The goal with Index Funds is to invest and hold for the long run. You will earn dividends along the way and earn the market return. Ensure to hang on for more than a year before switching to a different fund or liquidating.
Armed with this knowledge, you will be an expert Index Fund picker. Go forth and build yourself a cheap and diversified Index Fund portfolio!
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