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Index Investing: The Triumph of the Passive Investor

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Index investing has become the go-to strategy for passive investors looking to get into the stock market. We unpack the pros and cons of index funds compared to individual stocks.

A chart showing the performance of an index fund compared to individual stocks

The past five decades have seen a seismic shift in the way investors approach the stock market. The world of investing has changed so much that now, more than half of the money in investment funds is indexed. This is due in part to the rise of low-cost exchange-traded funds (ETFs), index funds, and other passive investment vehicles.

The rise of indexing has been a game-changer for passive investors. Index investing has been described as the “lazy” default for investors who don’t want to actively manage their portfolios. But even for more sophisticated investors, index funds can be an attractive option.

Index funds allow investors to buy into a basket of stocks that represent an index, such as the S&P 500. This gives investors broad exposure to the economy by allowing them to buy a “slice” of great American businesses like Berkshire Hathaway, Amazon, and Microsoft. It’s an efficient way to diversify your portfolio and can be much less expensive than buying individual stocks.

However, there are some drawbacks to index investing. For one, you may be missing out on potential gains if there are stocks that outperform the index. Similarly, the performance of the index can be affected by the performance of the worst-performing stocks in the index.

Another factor to consider is that index funds are not actively managed. This means that if the index is underperforming, the fund manager won’t be able to take action to try and improve the performance.

Finally, there’s the issue of cost. While index funds are usually cheaper than actively managed funds, they still come with their own costs. For example, ETFs may incur trading commissions when you buy or sell shares. Similarly, index mutual funds may charge an annual fee for management and other costs.

For anyone looking to start investing in the stock market, you’ll be faced with the pros and cons of individual stocks versus index funds. Both have their own advantages and disadvantages and which one is right for you will depend on your own risk tolerance and financial goals.

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