Investing in index funds: 3 key questions

15 May 2019 by National Bank
Index funds

Have you always wanted to invest in the stock market to get better returns, without suffering the repercussions of large fluctuations in specific securities? Index funds might be the right solution to add to your investment strategy. Just be sure to ask yourself these three questions before taking the plunge. 

An index fund is an investment fund that replicates the composition, performance and risk of a stock index. The S&P/TSX 60, which includes major Canadian companies, and the Dow Jones, which includes the 30 biggest industrial companies in the United States, are two examples of indexes.

The performance of exchange traded funds (ETFs) is generally assessed over the longer term. They require a relatively small minimum investment and offer a fairly low management fee compared to an actively traded investment fund or a portfolio manager who works directly for you. They are part of an overall investment strategy to diversify your investments and protect you from interest rate fluctuations.

The returns, however, can be difficult to predict. These funds require discipline against selling quickly when there are losses because they will likely recover and grow in the long term. You also have to realize that there are no guarantees when it comes to investing and, depending on which funds you choose, the risk may be higher.

Do you have the right investor profile?

These funds follow the performance of the market. Because they fluctuate daily, they might not be the best investment product if you need a steady, guaranteed income. If your tolerance for loss is low, index funds shouldn’t represent your entire portfolio. In general, it’s not a good idea to put all your eggs in one basket when investing your money.

Based on your financial situation and goals, decide what percentage of your total investments these funds should represent to strike a balance that works for you. You can even purchase a group of index funds that corresponds to your profile and risk tolerance.

Patience and discipline are two essential qualities to have when you decide to invest in index funds and you should resist making hasty transactions. You might suffer some losses that you can recover from in a year or even over the course of a decade. That said, the variety of securities held in these funds, combined with their low cost, can yield average returns that are quite respectable. Even Warren Buffett, the famous American investor, recommends investment funds for the larger returns they yield over the long term.

Which index funds are right for you?

Index funds have an interesting advantage. According to Daniel Straus, a National Bank ETF specialist, they are the fastest way to a diversified portfolio. For instance, you can choose funds based on geography (Canadian, American or international funds) or industry (mining or technology).

There are so many index funds out there, it would be impossible to list them all. Some of the biggest are the S&P 500 and the Dow Jones for American funds, the S&P/TSX for Canadian funds and the MSCI for international funds.

There are funds based on emerging markets and new industries. These can be attractive because their management fees are generally lower than established funds. They can give you larger returns, but they also carry higher risk. This is especially the true with some technology indexes.

Some funds are copies of other funds, with just a few small differences, such as the FTSE, which takes its cues from the MSCI. In both cases, they focus on emerging markets, and the FTSE includes countries that are overlooked by the MSCI.

What makes up an index fund?

A fund includes several securities (Apple, Google, etc.). Each security has a different weight in the fund that is directly related to the percentage of the fund composition that it represents. These weights are limited to reduce the impact of a decline in value of a particular security on the overall return of the fund. Regulations have been established to help avoid crises like the one that happened to Nortel when the tech bubble burst. If the weight of a single security is too high, the impact of the loss is greater.

How do you invest in index funds?

It’s important to have basic knowledge about the market before investing in these funds. It’s equally important to know what you’re buying and to understand the composition of the indexes that interest you to make sure they correspond with your financial goals.

If you’re a seasoned investor, investing in index funds won’t give you any surprises. You can buy them directly on brokerage sites to build your long-term investment strategy or take advantage of short-term forecasts in a particular index. If you already have one of these accounts, you’re good to go.

Whether you’re new to investing or an old hand, it’s a good idea to speak with an expert to determine your investor profile and your needs. Together, you can develop an investment plan to help you reach your financial goals. There are many types of funds—you just have to find the one that’s right for you.

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