Index Funds

When it comes to investing, diversification is a key attribute that cannot be overlooked. The old saying of don’t keep all your eggs in the same basket is relevant in investing than anything else. Diversification is important as it balances out the risks involved. Not every sector grows at once, and not every sector is sluggish at once either. This is where the power of diversification lies. If you invest across sectors, you can be in an advantageous situation, compared to an investor who invests only in one specific sector. Index funds are an ideal tool to diversify your investments. They are a great way to manage the risks involved with investing.

How Do Index Funds Work?

Index funds are like mutual funds that is benchmarked against a market index and tries to match the returns of that index. Actively managed mutual funds usually aim to provide better than the underlying index’s returns, while an index fund aims to match the performance of the underlying index. An index may comprise of a certain number of stocks like the Nifty 50 (comprises of top 50 stocks by market cap). Now, all the stocks in this index do not have the same weightage, they are distributed basis their market cap. For example, Reliance industries in Nifty 50 has a weightage of more than 10%. Now, an index fund will distribute your investment in a similar ratio. They will cover all the equities of the index it is benchmarking against.

Who Should Invest in an Index Fund?

A beginner, starting their investment journey in the stock market can study the index funds. Celebrity investors like warren buffet, also endorse investing in index funds for newcomers. If you are an investor, spending hours researching about prospect stocks and are looking to avoid risk of volatility at the same time, then index funds are an ideal choice. Index funds are passively managed and tend to be more cost effective. Index funds are also a preferred choice for investors looking to get predictable returns from the market.

Things to Consider While Investing in Index Funds

There are several aspects to be considered before investing in an index fund. Let us understand them in detail.

  • Cost: Low cost are a great USP for index funds. As these funds are passively managed, the fund managers don’t have to dedicate significant time on these funds. This reduces the advisory costs in the long term. Whereas in an actively managed mutual fund, wealth managers aim to beat the performance of the indices and thus, they get involved in multiple rebalancing and trading to achieve the numbers. This increases the advisory fees and cost of investment.
  • Risk: Another significant factor to consider is risk. Index funds are a popular choice for investors who are risk averse. The low risk involved in passively managed index funds, compared to equity and actively managed funds is the primary reason why investors flock towards them. However, an investor should diversify their investments and should not rely only on index funds for capital appreciation.
  • Return: The returns from index funds are expected to be steady and predictable. If an investor is looking for high growth opportunity, then an index fund may not be the right choice. Index funds aim to replicate the returns of the index and do not aim to beat them with aggressive investing.
  • Investment Goals: Index funds are a great resource for new investors. However, considering these funds are passively managed, it will yield returns over a period, at a steady speed. Investors must be patient with investment tools like index funds as it takes a while to grow your capital. Index funds can be ideal to serve your long-term goals, however, for aggressive short-term goals you must look at other forms of securities.

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