For many people, the idea of putting their hard-earned cash into the stock market is daunting. After all, when you invest in stocks, there's always the risk of losing money.
On the other hand, investing in stocks opens the door to potentially big rewards. If you invest $500 a month in stocks over a 40-year period, and your portfolio generates an average annual 7% return (which is several percentage points below the market's average), you'll wind up with roughly $1.2 million. And that's by putting in only $240,000 of your own money.
Still, a lot of people are too nervous to buy individual stocks. If you're one of them, a good solution may be index funds.
Index funds are passively managed funds that aim to match the performance of the market indexes they're set up to follow. An S&P 500 index fund, for example, will have the goal of performing as well as the S&P 500 itself. While index funds certainly aren't risk-free, here are a few reasons you shouldn't be scared to put your money into them.
1. They offer solid diversification
One of the best ways to protect yourself from losses as an investor is to build a diverse portfolio. You could do so by handpicking a few dozen stocks across a range of market sectors. Or you could buy index funds that already do that for you.
Imagine you buy shares of an S&P 500 index fund. By doing so, you effectively get to own a piece of 500 different companies. It's hard to get more diverse than that.
2. They don't put the burden of research on you
If you're new to investing or don't trust your own research skills, index funds are a great choice for one big reason -- you get no say in the stocks you own.
Say you buy shares of an S&P 500 index fund. Any company that's part of that index suddenly gets a place in your portfolio. That, in turn, takes the burden off of you.
3. They tend to reward long-term investors
Like individual stocks, index funds tend to reward investors who stick with them for many years. Take the Schwab S&P 500 Index Fund (NASDAQMUTFUND:SWPPX). Since its inception in 1997, it's delivered an average annual return of roughly 9%, which is in line with the stock market's overall performance.
This isn't to say that its value hasn't fluctuated during that time, but on the whole, it's fair to say that it's met expectations.
Are index funds right for you?
One aspect of index funds that some investors don't like is not getting a say in the companies they own. After all, you don't get to dictate which companies are part of the S&P 500.
So if you buy S&P 500 index funds, you may get stuck owning a piece of certain businesses that don't align with your values. But if you can get past that, index funds are a solid bet for the average investor -- especially those who are skittish about dabbling in stocks in the first place.