A stock index consists of a basket of stocks that is meant to represent something else. Sometimes, this something else is an entire stock market. Other times, this something else is a section of a stock market that serves as a stand-in for either an industry or some other kind of segment. Whatever the case, it is very common to see interested individuals put their money in an index fund, which is either a mutual fund or an exchange-traded fund that tracks an underlying index.
Why Are Index Funds So Popular?
For starters, it is important to mention that Index funds are popular because the investment strategy called index investing is popular. Based on the name, it should come as no surprise to learn that this is when someone seeks to replicate the performance of a particular index by putting their money in the basket of securities that make up that particular index. It is a very passive way of investing, which can be contrasted with more active investment strategies that see interested individuals buying and selling stocks on a regular basis.
As for why index investing is popular, there are a number of factors behind its popularity. One, the current thinking says that people can't beat the stock market in the long run once both taxes and trading costs have been factored into the relevant calculations. Two, there is empirical evidence that index investing tends to beat more active management in the long run, meaning that the current thinking is far from being purely theoretical in nature. Three, index investing is a very useful way for investors to protect themselves from non-systematic risks because they have spread out their money rather than concentrate it in the stocks of a small number of companies.
Moving on, index funds are popular because they are the most practical way for most people to engage in index investing. To some extent, this is because of the time and effort needed to track an underlying index, which might not be as much as the time and effort needed for more active investment but is nonetheless very real. However, there is an even bigger problem in that tracking an index can get quite expensive, meaning that a lot of people can do their own index investing even if they wanted to do their own index investing. After all, the S&P 500 tracks 500 stocks. For that matter, the NASDAQ Composite tracks more than 3,300 stocks. As such, a lot of people choose index funds for the same reason that other people choose other funds, which is to say, pooling their resources with like-minded individuals so that they can benefit from investment opportunities that they can't capitalize upon on their own. Having said that, index funds do tend to have one more great advantage in the form of reduced costs thanks to lower management fees and expense ratios when compared with their more active counterparts.
Why Don't the Rich Invest in Index Funds?
Unsurprisingly, there have been a lot of recommendations for investors to put their money in index funds if they want to grow their wealth. Something that can seem rather strange when most of the rich have either no or next-to-no interest in index investing of their own. However, there is nothing nefarious about this because the rich are investing under very different circumstances from those of investors of much humbler means.
For instance, profit maximization isn't the sole consideration for most investors. Suppose that interested individuals have the chance to put $500,000 in an investment that should provide them with a very high return but nonetheless comes with a small risk of their investment losing 50 percent of its value. For someone in their 50s who has about $500,000 in their retirement savings, that isn't going to be a very attractive investment. Yes, the statistics say that they are likelier to gain than to loss. However, if the investment fails to work out, that is going to have an absolutely devastating effect on their quality of life for decades and decades to come. In contrast, if someone has $200 million, they can go for that investment with no worries whatsoever. Even if they lose 50 percent of their $500,000 investment, they will still have $195.5 million, which shouldn't have much of an effect on their quality of life if at all. In other words, most of us have to balance the pursuit of profit with the safeguarding of our wealth because things can go very poorly for us if a risky investment falls flat on its metaphorical face. Meanwhile, the rich can pursue high-risk, high-reward investment opportunities without worries because their wealth can make for a very effective cushion from such problems.
On top of that, it should be mentioned that the rich also have access to a much, much wider range of investment opportunities than most of us. One excellent example can be seen in how they can afford to sink their money into active investment funds run by the top talent in the relevant industry in an attempt to get higher returns than what the market offers even if that means that they will have to pay hundreds of thousands of dollars or more in fees. Besides that, the rich can make huge investments in the industries that catch their interest, as shown by the numerous business people who have winded up buying sports teams of one kind or another. For that matter, the rich can even sink their money into luxuries such as art pieces and sprawling real estate properties, which they can enjoy while still benefiting from their increase in value over time.
Summed up, there are sound reasons for the recommendation of index funds to normal investors. However, even though the reduced need for oversight is one of the main reasons for their popularity, interested individuals should still do their research about them. Simply put, generalizations can be very dangerous when it comes to money matters. For instance, it is true that index funds tend to be protected from non-systematic risk because of their diversification. Unfortunately, they may not be as protected as interested individuals imagine because a lot of them are based on market capitalization. Thanks to that, the performances of huge companies such as, say, Amazon can have a greater effect on the index funds' returns than what interested individuals expected.
Written by Allen Lee
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