An index fund investor has a portfolio made up of mutual funds that are constructed to match or track the components of a financial market index, such as the Standard & Poor's 500 Index (S&P 500). Index mutual funds provide broad market exposure, low operating expenses, and low portfolio turnover. Effectively, the average index fund investor is buying all of the S&P 500 companies at a low cost.
- An index fund investor is effectively buying all of the S&P 500 companies in a sector at a low cost.
- Index funds are ideal holdings for retirement accounts such as individual retirement accounts (IRAs) and 401(k) accounts.
- The total book value of all the underlying stocks in an index is expected to increase over the long term.
Index Funds and Potential Losses
There are few certainties in the financial world, but there is almost zero chance that any index fund could ever lose all of its value.
There are a few reasons for this. First, virtually all index funds are highly diversified. Most index funds attempt to mirror some large basket or index of stocks, such as the S&P 500, by simply buying and holding identical weights of each stock as the index itself. Thus, because an index fund's holdings are well diversified, it is virtually impossible that all of these holdings' market prices would fall to zero destroying the value of the entire index.
Consider randomly picking 100 companies. The odds that a single company of the 100 will go bankrupt might be quite high. However, the odds that each and every one of the 100 companies will go bankrupt and leave shareholders with zero equity is essentially nil. Thus, an investment in a typical index fund has an extremely low chance of resulting in anything close to a 100% loss.
Because index funds are low-risk, investors will not make the large gains that they might from high-risk individual stocks.
Banking on Book Value
Another reason that index funds are relatively low-risk is the overall stock market. Most index funds represent at least a portion or particular sector of the overall market. The overall market is almost certain to be producing tangible value over the long term. Therefore, the total book value of all the underlying stocks in an index is expected to go up over the long term. This ensures that any well-diversified index fund will not significantly decline in value over the longer horizon.
Because index funds tend to be diversified, at least within a particular sector, they are highly unlikely to lose all their value.
Index funds tend to be attractive investments for a well-balanced portfolio. In addition to diversification and broad exposure, these funds have low expense ratios, which means they are inexpensive to own compared to other types of investments. The wide variety of index funds allows the investor to dip their toes into a number of different industries, sectors, and stock classes without doing the legwork of due diligence on individual stocks.
For novice investors, long-term investors, and those who don't want to spend too much time managing the portfolio, index funds offer a relatively low-risk way to invest and gain exposure to a wide range of equities.