Yahoo Finance Jaspreet Singh: 4 Things You Need To Know About Index Funds
Many investors consider index funds to be among the best investments available. Warren Buffett, an American businessman and investor with a net worth of around $132 billion, has been a vocal advocate of investing in index funds. Index funds allow investors to invest in the entire market and earn passively without needing to check their stocks and alter strategies.
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While this has been a proven strategy, personal finance guru Jaspreet Singh has some words of caution. In a recent episode from his YouTube channel, Minority Mindset, he goes over a few things every investor should know about index funds.
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How Index Funds Add Value
Before investing any money in the stock market, it’s important to know how companies gain value. There are two ways for CEOs of publicly traded companies to keep their stock value high. The first way is to grow the company. According to Harvard Business Review, they can do this by creating new:
Processes
Experiences
Features
Customers
Offerings
Models
There is an alternative option, though, according to Singh. It is earning the favor of one of the four top American fund managers: BlackRock, Vanguard, State Street or Fidelity. These four institutions create the largest index funds, mutual funds and exchange-traded funds (ETFs), meaning that the companies added to the funds get more buyers and higher stock prices.
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4 Things To Know About Index Funds
While many often see index funds as a safe and wise choice for investors, Singh explains four things about them that you should know first — and cautions that this is the “dark side of index funds.”
How Index Funds Work
Purchasing an individual share of a stock means you own a small portion of that company. If the company you’ve invested in does well, the stock price may increase and make you a lot of money. Conversely, if the company does poorly or goes bankrupt, you will lose a significant amount or all of your investment. Since owning stock in a single company comes with a lot of risk, investors often buy many different stocks to diversify their portfolios and protect themselves from volatility.
An index fund bundles many stocks together, meaning you become a part owner in all those companies. Index funds are passive, meaning no manager decides which stocks to buy and sell. For example, the S&P 500 has a committee that selects stocks that meet certain criteria based on:
Financial viability
Public float
Adequate liquidity
Company type
Investing in an S&P 500 index fund is an excellent way to diversify your stock market investments and own slices of some of the top stocks like Microsoft, Apple and Nvidia. However, what most people don’t realize is that you’re also buying into companies you’ve likely never heard of. Because you buy into every stock in an index fund, it tends to inflate the value of many lesser-known stocks you probably wouldn’t invest in otherwise.
What the Risks Are
What you decide to invest in is your own personal preference, and Singh admits he can’t give universal advice to everyone. In Singh’s opinion, investing in any fund is generally a good idea, but it’s not a guarantee that you’ll always make money. It’s also a better option for some, depending on their investment goals.
Cash flow is important to Singh, so he targets funds that will pay him every three months. Other investors may invest with the goal of their investment appreciating over time. Either way, knowing the risks before putting money into an index fund is vital. Some of the common issues that can negatively impact your index fund investment include:
Limited flexibility: You can only trade shares of an index fund once a day.
Tracking errors: An index fund may not perfectly match the market or industry it’s tracking.
Performance: Market volatility, fees, expenses and trading costs may cause you to lose money.
How To Analyze an Index Fund
Singh breaks down three things you should note when researching index funds.
First, you’ll want to know the industry the index fund tracks. Index funds cover a range of industries, from real estate to healthcare to technology. You want to invest in an industry that you expect to gain value over the next decade.
The fees and expenses you’ll pay are another important aspect to consider when choosing an index fund. Each fund has different costs, which get automatically taken out. In most cases, the fees associated with index funds are much lower than those of mutual funds or ETFs. However, it’s still a good idea to know exactly how much you’re paying the fund.
Finally, Singh explains that you need to check the holdings, or companies included in the fund. Make sure you’re investing in companies you actually want to be part of and believe will grow in value. Additionally, different funds will weigh their holdings differently. Two index funds may invest in the same companies, but the amounts invested in each specific company may vary.
How To Use Index Funds To Build Wealth
Index funds can help you build wealth if done the right way, as investing in index funds over the long term allows you to withstand the ups and downs of the market. However, Singh explains that the way many people invest in index funds is wrong. Those who take some money, put it into a fund and leave it there won’t build wealth effectively.
Instead, Singh advises investors to build a passive investing system. To do this, you must first find a well-performing fund that will likely continue to add value for years. With a fund picked out, you can schedule routine investments in the fund, which could be weekly or monthly.
The key to this strategy is consistency, even if the market drops or it’s difficult to add money to the fund. By following your passive investing system for years, you’re very likely to build wealth through index funds over time.
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