Can an index fund investor lose everything? Probably not. This would entail all stocks in an index effectively going to a price of zero. Even if the companies that issued the stocks all went bankrupt simultaneously, investors would likely recover some money based on the book value of the firm as it sells off assets in liquidation.
An index fund investor owns 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 funds provide broad market exposure, low operating expenses, and low portfolio turnover. An S&P 500 index fund investor is effectively buying stock in all of the S&P 500 companies at a low cost.
- An index fund investor is effectively buying stock in all of the underlying companies in an index at a low cost.
- Index funds are ideal holdings for certain investors with individual retirement accounts (IRAs) and 401(k) accounts.
- The total book value of all of the underlying stocks in an index is expected to increase over the long term.
- Due to diversification and book value considerations, an index fund investor would almost never experience an absolute loss.
- Index funds are considered a relatively safe investment when compared to individual stocks.
What Is an Index Fund?
An index fund is a mutual fund or exchange-traded fund (ETF) that invests in the securities represented in an index. The fund's goal is to match the performance of the index. By investing in an index fund, an investor gets broad-based exposure to a market through a highly diversified portfolio of securities.
Index fund investing is known as passive investing due to an index fund's buy and hold investment strategy. This contrasts with an actively managed fund that attempts to outperform a benchmark index.
Understanding Index Funds and Potential Losses
While there are few certainties in the financial world, there's virtually no chance that an index fund will ever lose all of its value.
One reason for this is that most index funds are highly diversified. They buy and hold identical weights of each stock in an index, such as the S&P 500. Their goal in doing so is to mirror the performance of the index's holdings. Due to this diversification, it is almost impossible that every stock's market price could fall to zero at the same time.
Consider a random selection of 100 companies. The odds that a single company out of the 100 will go bankrupt might be quite high. However, the chance that each and every one of the 100 companies will go bankrupt and leave shareholders with no equity is essentially nonexistent. Thus, an investment in a typical index fund has an extremely low risk of resulting in anything close to a 100% loss.
Make no mistake, the possibility of loss of value exists. For instance, in a major sell-off, when an index itself loses value, an index fund holding the underlying securities of the index will also lose value. However, investors who hold on to their fund investments should see the fund value increase as the value of the index itself reverses course and increases.
Because index funds are low-risk investments, investors will not see the large returns that they might get from higher-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 sector of the overall market. The overall market is almost certain to produce tangible value over the long term. Therefore, total book value of all the underlying stocks in an index is expected to go up over the long term. This means that a well-diversified index fund should not decline significantly in value, given a long time horizon.
Benefits of Index Funds
Index funds are a great investment for those who don't want to actively manage their investments or fret over the day-to-day fluctuations in value of individual stocks. Those who prefer a more passive approach to investing lean towards index funds as they offer a passive investing strategy.
Although not as liquid as exchange traded funds, index funds can be bought and sold at the end of each trading day. Many investors choose to buy and hold their index funds for months or years.
In addition to diversification and broad exposure, these funds typically have low expense ratios, which means they are inexpensive to own compared to other types of investments.
What's more, index funds have low turnover cost. Securities in an index fund aren't bought and sold often. They're bought and held. An index fund's goal is to match the tracking behavior of the index it follows.
Variety of Choices
The wide variety of index funds available allows investors to dip their toes into a number of different industries, sectors, and stock classes without doing the legwork of research and due diligence on individual stocks. Of course, by investing in a variety of diversified funds, investors can increase diversification even more.
Diversification may be the benefit that spurs so many investors to choose index funds. Again, this broad exposure is the main reason why an index fund reduces risk and why it could never fall to a value of zero.
The dozens, hundreds, or thousands of underlying stocks mean that even if one company goes bankrupt, the effect on the index fund as a whole would be minor. Even if an entire sector were to fall, the fact that there are so many other pieces to your investment pie means investors are much less likely to see major fluctuations in value when compared to owning fewer individual company stocks.
Index funds can be a good choice for tax-sensitive investors. During downturns in fund performance, the availability of similar funds provides an opportunity for an easy tax-loss harvest strategy when it comes time to rebalance.
Index Funds to Consider
Unless you're a savvy investor with a specific reason to purchase an eccentric index fund, it may be smart to consider some of the more popular index funds. These may have significantly more diversification, as well.
Once you review the size and diversification of funds such as those below, you'll begin to see why it is nearly impossible for them to fall to zero value.
Fidelity ZERO Large Cap Index Fund
The Fidelity ZERO Large Cap Index Fund (FNILX) tracks the Fidelity U.S. Large Cap Index, which is essentially the same as the S&P 500. However, because Fidelity doesn't use the S&P name, it avoids paying licensing fees to State Street Corporation. As a result, it can offer this specific fund to investors with a flat expense ratio. That means all money invested in the fund is kept in the fund, never to be eroded by an expense ratio.
Vanguard Total Stock Market Index Fund Admiral Shares
Although the Vanguard Total Stock Market Index Fund Admiral Shares (VTSAX) has an expense ratio of 0.04%, it won't significantly affect returns. VTSAX is a highly diversified fund with over 4,000 stocks in its portfolio. The fund is also massively popular and manages over $300 billion in client assets.
Schwab Total Stock Market Index Fund
The Schwab Total Stock Market Index Fund (SWTSX) is similar to VTSAX. It's a mix of large, small, and mid-sized companies and offers as broad an exposure to the market as possible. The fund also offers an exceptionally low expense ratio at 0.03%. This is a great fund for those who don't want to have to monitor their investment constantly or be concerned with fees reducing gains.
Do Index Funds Eliminate Risk?
Much of it, yes, but not entirely. In a broad-based sell-off of a market, the benchmark index will lose value accordingly. That means an index fund tied to the benchmark will also lose value.
What Is the Risk Level of Index Funds?
No index fund is completely free of risk. However, these funds are considered to be some of the safest investments available due to their diversification. Diversification, by design, delivers lower risk.
Are Index Funds Considered a Moderate Risk Investment?
Index funds are usually considered a low risk investment. That's because index funds are highly diversified (to match the index they follow). Diversification wields enormous power in cutting risk.
The Bottom Line
Investors who buy index funds will not lose all of their investment. That's because they're investments buoyed by hundreds or thousands of underlying securities. As such, they're highly diversified, making it almost impossible for them to reach a value of zero.
For novice investors, long-term investors, and those who don't want to spend too much time managing a portfolio, index funds offer a relatively low-risk way to gain exposure to a wide range of equities.