Indexing is a passive investment strategy. It’s designed to replicate the risk level and rate of return of a market index by investing in an index fund. The fund is created by investing in the same securities and weightings of a particular index.
What Is a Market Index?
An index is a list of stocks that are grouped together to represent a specific portion of the stock market. The Dow Jones Industrial Average is an index that includes the 30 blue-chip companies considered to be leaders of the economy. The Standard & Poor’s 500 includes the stocks of the top 500 companies in leading industries. Finally, the Wilshire 5000 Index includes all publicly traded companies in America.
- Lower cost is one of the biggest advantages of indexing. Mirroring the holdings of an index does not require a team of investment managers and research analysts. This reduces the fund’s management fee. They also don’t incur as many trading costs and other expenses. These are passed on to the investor in the form of higher returns.
- Tax efficiency can also be a consideration. Generally, holdings in an index fund require lower trading activity, which results in fewer capital gains and more favorable taxation.
- Diversification is a high-value benefit of indexing. By investing in a broad array of securities, the fund can guard against individual stock fluctuations.
- Consistency is a key factor when choosing an investment strategy. An index fund manager doesn’t select the stocks in which to invest. The fund mimics the index, so there’s no chance for a sudden shift in holdings. Index investing easily lends itself to consistency and doesn’t allow for deviation from the original plan.
Index investing can be a strong addition to any portfolio. This is because of its broad diversification and investment style consistency, but also in terms of cost efficiency.