Index funds are popular investments, and there are good reasons for that,
but I often see people misunderstanding some of the risks you take with
index funds. So let's talk about that. In this video, we'll briefly review
how index funds work, what some of the risks are, and then how
you can manage those risks as you use these instruments. A key feature
of index funds is their low cost, and since high expenses mean you
end up with less money later, then the lower your expenses,
the better...[all other things being equal]. With an index fund, you're
typically going to have a relatively low annual expense ratio, meaning you
pay very little for the management. The. Tax cost of owning an index
fund can also be quite low because they have relatively low turnover,
meaning they're not buying and selling investments quite as frequently as
a lot of active funds, and that means you don't take capital gains
as often. When it comes to investment strategy, index funds are what's called
passive investments, so you don't have a manager or a management team that's
trying to pick which investments are going to do the best and which
ones to avoid, and that way you're not paying for that team and
paying for all their travel and all of the other expenses that might
come with active management. The fact is that very few investments have
off the charts performance, so you might be able to think of some
big names, and maybe you want to find "the next Amazon"
or something like that, but it's very difficult to do this.
So, by owning lots of different investments, you improve the chances of
being there for those few that do extremely well. Just a friendly reminder,
This is just a short video. I can't possibly cover everything you need
to know, so please do a lot more research, and I highly suggest
checking with a professional to get individualized advice. So index funds
can be an excellent choice for investors, but something that confuses people
is... Maybe because they hear so many good things about it,
they might even hear that they're the "best" type of investment or that
they're the "safest" investment. And the safest part, in particular, is
something I want to talk about in detail, because you can actually take
quite a bit of risk with an index fund. It's kind of like
saying that salsa isn't spicy. Sometimes it is and sometimes it isn't.
It just depends what you have inside of it, and the same is
true for those index funds. An index fund simply tracks an index or
a grouping of stocks or bonds, but this grouping typically has some common
characteristic, so it might be 500 of the biggest companies in the US,
for example, which might describe the S & P 500, so if whatever those
securities are happen to be risky, and they will go up and down
a lot, then so will any index fund that tracks it.
When it comes to stocks, you can certainly lose money by investing in
stocks, also known as equities, you obviously do that hoping that you will
get some long term growth, but historically, we've seen that you have to
put up with some ups and downs along the way. Let's.
Look at an example of that. So if we go back to the
great financial crisis, this is around 2007 2008, the S & P 500 index
was down about 38% in calendar year, 2008. In fact, it was down
more than that at some point during the year, but it ended the
year Down 38%. Mutual funds that track the S & P 500,
like S & P 500 index funds, also lost a similar amount,
so the category average during 2008 was negative 37.8%. And what we're looking
at here is just a typical S & P 500 Index Fund,
so I'm not recommending for or against any particular fund or fund family.
This is just an example for illustration that shows you what happened with
the average S&P 500 fund, regardless of the issuer, they were all roughly
like this. There. Are many other indices or indexes out there that you
can use to track stock and bond markets and other areas of the
markets, so you have the Russell 2000, which is smaller companies in the
US, or the Wilshire 5000, which attempts to track all of the companies
in the US, but the point is that there are a lot of
different measurements you can use to track these different market sectors,
and so for example, you might ask about Bond Index funds. Are those
less risky? And traditionally, yes, bonds are viewed as less risky than
stocks, but they can certainly lose money. So if we look back at
2013, for example, that was a year when bonds lost some money and
the losses were not as great as you might see in some of
the worst stock market crashes, but if you go with the assumption that
index funds and bonds are safe, then you would perhaps be disappointed and
surprised. So if you do want to manage risk, then you can add
in some bonds to your portfolio, but you want to maybe think about
using shorter term and higher quality bonds, because those might have the
lowest risks when compared to long term bonds or "junk bonds,"
also known as high yield bonds. But what you need to remember is
that there's no such thing as a free lunch. So if you're going
to go for safety, you might end up getting lower interest rates and
returns from your bonds. It could work out well, or it might work
out not so great, it just depends, and this is part of being
a long term investor: That you have to accept these trade offs.
What's more... It can get really complicated as an investor, so as just
a quick example, we can look at during 2020, roughly five stocks made
up about a quarter of the S & P 500. So you might have
thought I'm in the S & P 500, I've got exposure to 500 different
issues, but in fact, about a quarter of your portfolio in that fund
would have been roughly five stocks. That's just a feature of how the
S & P 500 is designed, and it has pros and cons.
It happened to work out well, if you were along for the ride
that whole time, because those five stocks did quite well, but depending
on timing and other factors, it can sometimes not be ideal for investors.
There are other index strategies that can get convoluted and we're not going
to get into that, but I just want you to be aware of
this type of thing. Given all of that, you might wonder if I'm
saying that index funds are bad, and that is definitely not the case.
In fact, I use them quite a bit when I build portfolios for
clients, so I just don't want you to get caught by surprise if
you're thinking that you're not taking much risk in a stock index fund
or even a bond fund. If you found this helpful, please leave a
quick thumbs up, that's a signal to me to keep putting out information
like this, so thank you and take care.