Index exchange-traded funds (ETFs) are one of the most popular investments for beginners and seasoned pros alike. Even if you'd like to invest in individual stocks, having an index fund at the foundation of your investment portfolio can still be a smart move. Here are three reasons you should consider it.
1. They offer instant diversification
Index ETFs are bundles of stocks you buy together. With this single purchase, you instantly get part ownership in hundreds of companies.
Spreading your money around between many stocks is smart because it reduces your risk of loss. If one stock is performing poorly, that's a huge problem if you've invested all your money in two or three stocks. But a single, poorly performing stock is going to represent a much smaller share of your assets if you have your money in 100 different stocks.
It is possible to diversify your investments yourself by choosing a variety of stocks and investing in them individually, but this is much more time-consuming. It requires you to stay up to date on what's happening with each company and buy and sell stocks as needed.
With an index fund, you don't have to worry about that. Indexes usually contain the stocks of well-known, industry-leading companies, and if the companies start to show signs of serious decline, they're removed from the index and your index fund. For example, the S&P 500 index contains 500 of the largest publicly traded companies in the U.S. If a company falls off that list, any S&P 500 index funds will be updated to reflect this. So your money will always be invested in strong companies.
2. They're affordable
Index ETFs charge annual fees, known as expense ratios, which cover the cost of managing the fund. This is how mutual funds work also. With actively managed mutual funds, fund managers are responsible for choosing which investments they think will beat the market and then buying and selling accordingly. It's a lot of work, and the expense ratios can cost you well over 1% of whatever you have invested in the fund each year.
Index funds typically have much lower expense ratios -- in some cases as low as 0.03%. That means you only pay $3 per year for every $10,000 you have invested in the fund. You get to keep the rest.
Index funds are able to keep costs so low because the stocks in the funds rarely change, which means less work for fund managers. They're able to pass this savings along to investors in the form of lower fees.
3. They tend to have strong returns
An index ETF's annual return tends to be just slightly below that of the index itself. That's because index funds have some fees that reduce your profits slightly. But despite this, they can still generate some strong returns.
The S&P 500, for example, has had a compound average annual growth rate of 10.7% over the last 30 years. There have been ups and downs in that time, but if you'd had an S&P 500 index fund during those three decades, you would've grown your wealth significantly. A single $10,000 investment in 1991 would have been worth over $210,000 by the end of 2020.
Of course, historic returns don't guarantee future performance. But given that index funds are composed of the stocks of many innovative and industry-leading companies, it's reasonable to think they will probably perform well over time.
Every investment has its risks and its costs, but given all the advantages an index fund has to offer, you should definitely think about adding one to your portfolio. You can still purchase additional stocks if there's something you really want to invest in. But an index fund will give you a broad base of stocks that can help you grow your nest egg without requiring you to spend too much time managing your investments.