Stocks, particularly index funds, have remained one of the most favored financial investment by Americans with an aim of building their wealth in the long run. Consequently, there is a need to explain the advantages and disadvantages linked to the use of this investment approach in order to assist in the decision making process.
Besides, index funds are easy to invest in. They do not require a lot of time on research on individual securities or in making changes to their portfolios often. Since there is little intervention from the fund manager of the index, these funds are suitable for those who are not experienced in investing or those who want to have simpler ways of investing.
Understanding the benefits of index funds
Thus, to say that the advantages of index funds stop at cost and simplicity would be a drastic understatement. The second possible advantage of the strategy is that it spreads risks thus making the overall risk level in Investor’s portfolio lower.
In this way, the choice of a rather wide brush investment in the form of a broad market index like the S&P 500 means that the investor is exposed to the broad market in terms of business categories. But by so doing it is possible to spread the risk as to reduce the effect of poor performing stock or grouping of stock.
In the long-run, the various prices of an array of stocks level off and hence, that makes index funds quite stable. Much of this stability is particularly seen by those planning for retirement or to have other monies set aside for future use.
Cost-effectiveness and fees
Another great advantage of index funds which people have embraced is the expenses that come with it. These funds are passive funds which are established with the intention of mimicking the performance of a given index, such as the Dow Jones Industrial Average Index, and are not managed actively so as to be able to post betters returns than the said index.
Index funds are cheap investment as they do not involve active management and thus entail lower costs in research, purchases and, selling. It means that expense ratios for investors become lower which in turn can dramatically influence their long-term returns. Finally, one will notice that small divergence in fees leads to significant divergence in the total value of investments.
Long-term performance
Index funds can also gain advantage from the long term positive performance trends and hence be invested in. Looking at the history of markets, one will be in a position to noting the fact that market prices are actually characterized by an upward trend in the long-run though they sometimes fluctuate in the short-run.
These considerations imply that patience and business-savvy are highly appropriate while investing in index funds, aware of the long-term benefits that these instruments are capable of providing to shareholders. It also emphasizes on timely savings whether in form of a saving’s scheme for instance retirement plan so that the interest maintained compound.
Assessing the risks of index funds
However, it is crucial to note the disadvantage got with index fund investments despite the numerous advantages available. Thus, the first type of risk that is characteristic of index funds is market risk, standing for the index fund’s ability to produce returns that correspond to the overall market.
However, it also poses a disadvantage that including a share in index funds which are generally affected by the market at large, the value of investments is likely to reduce during the periods of market low cycles. This is maybe a challenge especially for investors with short investment periods or those people who have a bill to pay, today!
Market volatility
Market risk is therefore a risk that every investor has to encounter no matter the kind of investment he /she is involved in. Regarding this, index funds are not invulnerable since its value is adjustable based on the occasion in economy, politics, and society.
For instance, changes in global economic status such as a downturn, disasters such as floods or hurricanes or social events ranging from politically instigated conflicts to terror threats are likely to cause drops in the market indices, a reality that reduces the value of index fund investments.
Lack of flexibility in stock selection
The other potential outcome to note regarding index funds is that there is little room in managing the index fund to choose favored stocks. In its concept, an index fund is designed to mirror the corresponding index market so that there is no flexibility to remove poor performing stocks or industries that an investor does not wish to invest in them.
This lack of control can be said to be irritating especially for those who would love to have more control on their investment decisions or those who would like to invest based on some ethical or environmental convictions. For example, an investor may not wish to invest in a particular industries like tobacco or fossil, which an investor cannot do with index fund.
