Investing in the stock market isn't for the faint of heart. Stocks are extremely volatile, and watching your portfolio value go up and down during periods of turbulence is enough to make even the most seasoned investor break into a full-body sweat. But if you're particularly skittish when it comes to investing, there's one option you may want to explore: index funds.
Why index funds work for nervous investors
When you buy individual stocks, there's a lot at stake -- and there's also a lot of legwork involved. You need to look out for a number of key things, including:
- Cash flow
- Company debt
- Competitive advantage
That's an especially tall order if you're new to investing. But even if you've been at it a while, buying individual stocks requires you to make tough decisions that could end up backfiring. And that's why index funds may be a better choice if you're the nervous type when it comes to investing.
With index funds, you're not buying or vetting individual companies. Rather, you're buying a passively managed fund that tracks a specific index it's tied to.
For example, an S&P 500 index fund will aim to match the performance of the S&P 500, which is an index comprised of the 500 largest trading companies by market capitalization. That's a pretty good measure of how the stock market is doing on the whole.
It should make you less nervous as an investor to invest in index funds because, while it's possible for them to decline in value, that generally only happens when the entire market takes a hit (especially when we're talking about S&P 500 index funds). Or to put it another way, with index funds, you won't end up kicking yourself for choosing one specific bad investment. Rather, you'll gain when the broader market gains, and when stocks are down, your portfolio will be similarly down -- but it probably won't be worse than the market.
Another benefit of index funds is that the performance of individual companies matters less. When you buy a specific stock and its earnings report falls short of expectations, that stock can plummet. But if that single stock is just one of many in an index fund you hold, it won't have the same impact on your portfolio.
Index funds also offer built-in diversification because, again, you're buying a basket of stocks, as opposed to individual stocks. If you're worried about losing money in the stock market, index funds can, to some degree, alleviate that concern, because if a single company or market segment takes a hit, it may not affect you that much.
Is there a downside to index funds?
One thing you should know about index funds is that they're not designed to beat the market. If you invest in actively managed mutual funds -- those with experienced fund managers at the helm -- you might beat the market. But many actively managed funds repeatedly miss their benchmarks, and in exchange for that hands-on approach to picking stocks, you'll pay substantial fees -- up to 10 times more than what you'll pay to invest in index funds.
Still, if you want to do better than the broader market, an actively managed mutual fund may be a better choice. That way, you're putting your investment decisions in the hands of people who analyze stocks for a living.
Another drawback of index funds is that you don't get a say in your investments. If there's a specific company you don't like, you may wind up investing in it anyway. But if you're the type who's nervous about picking stocks in the first place, you may not want a say in your investments. Rather, you may be more comfortable having that decision made for you.
Push past your fear
Index funds won't prevent you from taking losses in your portfolio, but they will give you the peace of mind that comes with knowing you're invested in the broader market. If the idea of picking stocks makes you anxious, try focusing on index funds. If anything, it'll take a load off your shoulders on the road to building wealth.