ADVERTISING DISCLOSURE: TheFinanceTwins.com is an independent advertising-supported site. The offers that appear on this site are from affiliate sales networks, and TheFinanceTwins.com receives compensation for sending traffic to partner sites, such as CreditCards.com. This compensation may impact how and where links appear on this site. TheFinanceTwins.com does not include all financial companies or offers available.
Anyone who’s been to our site for longer than 3 seconds knows we LOVE index funds. In fact we rely on index funds as our primary investments. However, some investors fear that index funds will cause the stock market to break. Namely, what if everyone invested in index funds? But before we dig into that, let’s define explore the benefits of index funds and then define what they are.
4 Reasons We Love Index Funds
You are guaranteed to earn market returns (something that half of PROFESSIONAL investment professionals can’t do)
You pay much lower fees and taxes than if you were moving in and out of individual stocks
It’s so simple to choose awesome index funds to invest in.
With the advent of target date funds, you can even simplify your investments and own a single index fund.
What Are Index Funds?
A stock index fund is simply a group of stocks that you can buy as a single bundle. The most popular index funds are built to track a specific index like the S&P 500. By purchasing an index fund, you will own a whole group of stocks. (Bond index funds also exist, but let’s focus on stocks to keep things more simple.)
Owning an index fund like an S&P 500 index fund provides diversification because you will, in essence, own small slivers of 500 different companies, instead of only a handful. Diversification basically means spreading your money out among many investments. By doing this, you reduce the riskiness of your portfolio. In other words, you lower the chance that you’ll lose A LOT of you wealth due to a few of your investments losing value while not meaningfully lowering your returns. The power of diversification will protect your portfolio from the risk of picking the ‘wrong’ stocks. In your index fund, some stocks may go up while some will go down in value. But historically, the broader stock market has always increased over long periods of time. This is why they are such a wonderful way to invest.
Could The Stock Market ‘Break’ If Everyone Invested In Index Funds?
In theory, yes. But in reality that won’t be happening any time soon for a few reasons.
The prices of stocks in the stock market are set via supply and demand. There’s essentially an invisible electronic middle man who matches buyers and sellers who place bids for stocks at certain prices. As the computers match buyers and sellers, the current stock price will move up and down to the current price at which people are willing to buy and sell.
For example, let assume you own Tesla stock that you want to sell and it’s currently trading for $280. You are welcome to place a sell order at a price of $350. However, if no one else believes that Tesla is worth $350 then you probably will not be able to sell your shares for $350. You’ll then have to keep lowering your asking price until someone is agrees with your price. This is a high level example of how the market determines stock prices.
Some people worry that if everyone decides to only invest using index funds, then the stock market will stop working. For example, if everyone buys index funds, the values of the stock prices of the underlying companies won’t reflect the fair value of the companies in the stock market. Instead the prices of stocks will simply reflect the the inflow of funds to indexes.
Do Index Funds Help Determine The Fair Price Of Stocks?
No, index funds don’t participate in the price discovery process in the same way as the traditional practice of buying and selling individual stocks. At a basic level, index funds are pools of money that buy groups stocks in certain proportions at the current stock market price. They don’t take a view on what the price of a stock should be. They simply buy an entire group of stocks when investors invest money into the index fund.
What this means is that if every investor in the world only purchased the same index fund, then the market of buyers and sellers would no longer set the fair market price of the stocks in the stock market. In a sense, the stock market would no longer be a “market”.
Remember, picking individual stocks is for dummies.
What If Everyone Invested In Index Funds Funds?
In theory, it’s a valid concern that uniform adoption of index funds could cause the market to stop working efficiently. However, the vast majority of the public stock market would have to be held by index investors for the market to break down and stop working as intended. Economist Larry Swedroe, for example, believes that index fund ownership would need to account for more than 90% of all stock ownership for index funds to cause a problem.
According to Bloomberg, index funds only own 18% of the stock market. In other word, we still have a long way to go before we really need to worry about index funds causing problems. Index funds were created by John Bogle at Vanguard in the mid 1970’s, so if the past 45 years are any indication, there is still A LOT of time before index fund ownership gets anywhere close to 90% of all stocks.
If everyone were to invest their entire savings into an S&P 500 Index Fund instead of keeping it in a savings account , there would be several potential outcomes . Firstly , the stock market would experience a significant increase in demand , driving up the prices of stocks within the S&P 500 Index .
Increased Volatility: With everyone buying and selling stocks in the stock market, prices would likely swing more dramatically. This is because there would be a constant churn, with less emphasis on long-term fundamentals and more on short-term sentiment.
Some index funds provide exposure to thousands of securities in a single fund, which helps lower your overall risk through broad diversification. By investing in several index funds tracking different indexes you can built a portfolio that matches your desired asset allocation.
Short-term downside risk: Index funds track their markets in good times and bad. They can be volatile places to put your money, especially when the economy or stock market isn't doing particularly well. When the index your fund is tracking plunges, your index fund will plunge as well.
So while it's theoretically possible to lose everything, it doesn't happen for standard funds. That said, an index fund could underperform and lose money for years, depending on what it's invested in. But the odds that an index fund loses everything are very low.
Disadvantages of index funds. While index funds do have benefits, they also have drawbacks to understand before investing. An index fund tends to include both high- and low-performing stocks and bonds in the index it's tracking. Any returns you earn would be an average of them all.
Tracking error may occur in an index fund due to liquidity provisions, index constituent changes, corporate actions etc. This is a major risk in index funds. Index funds do lose out on the expertise of the fund manager and the structured investment approach that an active fund manager brings.
As with other mutual funds, when you buy shares in an index fund you're pooling your money with other investors. The pool of money is used to purchase a portfolio of assets that duplicates the performance of the target index. Dividends, interest and capital gains are paid out to investors regularly.
When there are no buyers, you can't sell your shares—you'll be stuck with them until there is some buying interest from other investors. A buyer could pop in a few seconds, or it could take minutes, days, or even weeks in the case of very thinly traded stocks.
A common rule of thumb, the rule of 72, states that you can know how long it'll take for your investment to double by dividing 72 by the rate of return. A 10% annual return means your money should double every 7.2 years.
How many S&P 500 index funds do I need? S&P 500 index funds will be nearly identical to one another in terms of their performance and their holdings, or the particular stocks held within the fund. Investing in multiple S&P 500 index funds will not necessarily further diversify your portfolio.
Ideally, you should stay invested in equity index funds for the long run, i.e., at least 7 years. That is because investing in any equity instrument for the short-term is fraught with risks. And as we saw, the chances of getting positive returns improve when you give time to your investments.
Some millionaires are all about simplicity. They invest in index funds and dividend-paying stocks. They seek passive income from equity securities just like they do from the passive rental income that real estate provides.
The S&P 500 carries market risk, as its value fluctuates with overall market performance, as well as the performance of heavily weighted stocks and sectors. For example, the technology sector performed poorly in 2022 and was a large contributor to the index's correction that year.
Investors who buy index funds will not lose all of their investment. That's because they're investments buoyed by hundreds or thousands of underlying securities. As such, they're highly diversified, making it almost impossible for them to reach a value of zero.
If you're new to investing, you can absolutely start off by buying index funds alone as you learn more about how to choose the right stocks. But as your knowledge grows, you may want to branch out and add different companies to your portfolio that you feel align well with your personal risk tolerance and goals.
Indexes are set portfolios. If an investor buys an index fund, they have no control over the individual holdings in the portfolio. You may have specific companies that you like and want to own, such as a favorite bank or food company that you have researched and want to buy.
There are hundreds of funds, tracking many sectors of the market and assets including bonds and commodities, in addition to stocks. Index funds have no contribution limits, withdrawal restrictions or requirements to withdraw funds.
Investors can capitalize on the advantages of including index funds in their portfolio, including: Low fees: Low fees mean higher returns for investors. For funds that are passively managed a smaller percentage of profits are devoted to management fees.
Address: 55021 Usha Garden, North Larisa, DE 19209
Phone: +6812240846623
Job: Corporate Healthcare Strategist
Hobby: Singing, Listening to music, Rafting, LARPing, Gardening, Quilting, Rappelling
Introduction: My name is Foster Heidenreich CPA, I am a delightful, quaint, glorious, quaint, faithful, enchanting, fine person who loves writing and wants to share my knowledge and understanding with you.
We notice you're using an ad blocker
Without advertising income, we can't keep making this site awesome for you.
