Index funds are extremely popular investments for a number of reasons, but they can also be confusing, especially if you're new to investing. They can lead to a number of misconceptions that can cause people to either avoid index funds or overinvest in them, believing they can deliver returns that aren't realistic.
Below, we'll talk about three of the most common misconceptions some Gen X investors have about index funds, as reported in a recent survey by investment manager Natixis, along with some realities behind them.
Image source: Getty Images.
1. Index funds aren't cheaper than other types of investments
Index funds are among the cheapest investments you can find. A lot of this has to do with how they're constructed. Funds are bundles of investments you purchase as a group. Index funds are designed to mimic the performance of a specific market index, like the S&P 500. They contain the same investments in roughly the same quantity, so when the index does well, the fund does well, too.
All funds require some oversight from managers who monitor the funds' performance and buy and sell assets as needed. Actively managed mutual funds with stocks hand-chosen by fund managers can require a lot of work. This raises the expense ratio, or annual fee, that shareholders pay. Some of these funds can have expense ratios greater than 1% -- that is, you pay more than 1% of what you have invested in the fund each year to the fund manager.
Index funds, by contrast, require a lot less work because the companies in the index don't change very often. Since there's less for fund managers to do, these investments also have significantly lower fees.
Some of the best S&P 500 index funds, for example, have expense ratios of just 0.03%. That means you would only pay $3 annually for every $10,000 you have in the fund compared to $100 per year for $10,000 in a fund with a 1% expense ratio.
Lower fees help you hold on to more of your cash over time, and this can help you grow your wealth more quickly. That's one of the reasons they're popular with investors of all types.
2. Index funds are less risky
On the other side of the coin, many Gen X investors surveyed by Natixis said they believe that index funds are less risky than other types of investments.
There is a bit of truth to this. Index funds give you an ownership stake in dozens of companies or even hundreds. This diversification reduces your risk of loss more than investing all your savings in one or two stocks, for example.
But it's not true that there are no downsides to investing in index funds. It's still possible to lose money, particularly when the economy is struggling.
But it's important not to panic during these times. These losses ultimately are temporary and the funds eventually rebound if you just stay the course.
3. Index funds give you access to the best opportunities in the market
Many of the Gen X investors surveyed also said they believe that index funds gave them access to the best opportunities in the market.
Again, there's a grain of truth here. Investing in index funds will give you access to some great stocks with excellent long-term growth potential. But at the same time, you'll also get ownership stakes in some other stocks that might not perform so well.
This shouldn't dissuade you from investing in index funds, but it is something you should be aware of, too. They're not magic investments that will turn you into a millionaire overnight, but they can help you diversify your savings and grow your wealth at a reasonable cost.
Index funds can form a great foundation to your portfolio, but you don't have to limit yourself to just these. If you feel confident in your ability to pick stocks, you can add some of those as well. Just understand how this affects your portfolio's degree of risk.
