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Are Index Funds a Good Choice for You? Ask Yourself These 3 Questions to Find Out

By Maurie Backman – Sep 24, 2020 at 7:36AM

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Index funds are an easy way to invest -- but they're not for everyone.

You'll often hear that index funds are a solid investment at any age, and there's a lot of truth to that. When you buy index funds, you're effectively investing in a bucket of different stocks, albeit with a single purchase.

Index funds, as the name implies, are funds that are tied to specific existing indexes and that typically invest in all of the companies those indexes include. An S&P 500 index fund, for example, will generally invest in the 500 largest companies by market capitalization. It's also possible to find index funds that center on one specific industry -- you definitely have choices.

That said, index funds aren't for everyone. If you're on the fence about index funds, ask yourself these questions.

Smiling man at laptop

Image source: Getty Images.

1. How much time do I have to spend vetting stocks?

The beauty of index funds is that they take the guesswork of investing out of the equation. With index funds, you don't have to spend hours researching stocks; you can simply look at the performance of a specific fund and add it to your portfolio if you like what you see. On the other hand, the downside of index funds is that you don't get a say as to which stocks they include. If you want that level of control over your portfolio, you'll need to hand-pick your stocks yourself.

2. How much do I care about beating the market?

Index funds aim to match the performance of the indexes they're tied to -- not surpass it. If your goal is to beat the market, you'll need to choose individual stocks or look at investing in actively managed mutual funds, which charge higher fees because they're run by hands-on managers who follow the market and make decisions based on unique strategies. Of course, there's nothing wrong with wanting to beat the market. But if you're content with matching it, then index funds may be a less risky proposition. And from a cost perspective, you'll pay much lower fees with index funds than you will with actively managed mutual funds (many of which fail to outperform index funds anyway).

3. How diverse is my portfolio right now?

A diversified portfolio can protect you from losses when the stock market crashes and set you up for substantial gains over time. If you've been struggling to diversify your portfolio, index funds could be a good solution, because, again, you're putting your money into a bundle of stocks rather than one or two individual companies. On the other hand, if you already own a few dozen stocks from a variety of market segments, you may not be worried about diversity in your portfolio. If that's the case, you can instead focus your efforts on finding individual stocks that offer exceptional value.

Index funds are an easy way to invest, and they may be a good bet for your portfolio, either on their own or in conjunction with individual stocks. However, if you're willing to put in the time or pay the fees, you may find that individual stocks and actively managed mutual funds do a better job at helping you achieve your personal investing goals.

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