Stock investing is risky whether you invest in an index fund or individual stocks. An index fund gives you an opportunity to hold a basket of stocks; for example, some index funds are invested in all the stocks in the S&P 500, thus shielding you from the brunt of any individual company's risk. The benefit of index funds lies in their diversification. An individual stock investment, however, exposes you not only to the market but also to the specific company risk.
Index fund investing provides more diversification than putting your money into individual stocks. Even the savviest investment professionals have trouble putting together a portfolio of winning stock picks. By choosing an index fund, you're gaining exposure to a wide variety of stocks representing different industries. This means you're not limited to the performance of any one particular stock. If some stocks decline in value, others in the index fund may pick up the slack as an offset.
Index funds incur lower fees than other types of investments, because they are not actively managed -- in other words, there is not as much buying and selling taking place in the portfolio. Remember, an index fund mimics the performance of a specific index, so the people who manage the fund must simply ensure that they maintain the right amount of stock -- there's no guesswork, and that savings is passed on to the investor. On the other hand, you incur broker's fees and commissions every time you buy and sell a stock.
An index fund can be a great investment, particularly if there is a lot of volatility in the stock market. Because an index fund includes many stocks, the swings that some stocks experience are muted by stocks generating stable and steady returns. Index funds have been shown to actually outperform actively managed mutual and hedge fund because of lower transaction fees, management and performance fees. In addition, it is very rare to find actively managed funds that convincingly and consistently outperform the market.
Type of Index Funds
There are a number of index funds designed to fit investor preferences. Most index funds are weighted by a company's market capitalization, which is the current value all of its outstanding shares. Certain index funds are weighted by market cap, meaning that a rise in a company's stock price makes it a larger component of the index. A dividend-weighted index places emphasis on the dividend yield of the stocks that comprise the index. The dividend yield is a company's annual dividend divided by the stock price. An equal-weighted index assigns the same weight to all stocks in the index.