Investing your money is a good way to grow wealth, and in that regard, you have choices. You can buy individual stocks for your portfolio, or you can load up on index funds.
Index funds are funds that track the performance of a specific index. S&P 500 index funds, for example, are pretty popular because the S&P 500 itself is comprised of the largest publicly trading companies on the market. Of course, you don’t have to buy S&P 500 index funds. Rather, you can buy shares of a bond fund, or a fund that focuses on a specific market sector.
There are plenty of benefits to choosing index funds. For one thing, they charge extremely low fees — much lower than what you’ll pay for actively managed mutual funds. They also save you the legwork of having to research individual companies. And, adding index funds to your portfolio is a good way to diversify. If you buy shares of an S&P 500 index fund, you’ll gain exposure to 500 distinct companies in one fell swoop, and it really doesn’t get easier than that.
But while index funds are a suitable investment for a lot of people, and they’re an easy way to build a portfolio, they also have a couple of key drawbacks. And it’s important that you know what those are, especially if you’re planning to develop an investing strategy around them.
1. You won’t beat the market
The goal of index funds is to match the performance of the indexes they’re tied to. But if you want to beat the broader market, you’ll need to hand-pick stocks on your own or otherwise put money into an actively managed mutual fund that will charge you higher fees. Some investors don’t care about beating the market as long as their portfolios do well, but if that’s not you, and you want to beat the S&P 500, then an S&P 500 index fund won’t cut it.
2. You won’t get a say in your investments
Hand-picking stocks lets you choose where your money goes. If there’s a company you feel has great growth potential, or puts out a product you believe in, then you get to make the choice to add it to your portfolio. With index funds, you don’t get a say in which stocks (or bonds) make the fund. Rather, you’re effectively signing up for whatever bucket that index entails. This means that if you’re not a fan of a particular company, you may get stuck with it anyway.
Do the benefits of index funds outweigh the negatives?
For many people, they do. In fact, investing legend Warren Buffett is a firm believer that index funds are a great choice for the average investor.
But maybe you’re not the typical investor. Maybe you’re someone with lofty goals — beating the market and assembling a mix of stocks you vet carefully. If that’s the case, then don’t buy index funds, or don’t go heavy on them. There’s certainly nothing wrong with buying index funds and simplifying the investment process, but if the above flaws don’t sit well with you, don’t hesitate to put your money elsewhere.
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