How to Diversify With Index Funds

Index funds are attractive for several reasons, including diversification and low expense ratios. In regards to the former, when you purchase shares of an index fund, you're exposed to all the stocks in an index. The idea is that stocks that are appreciating will make up for stocks that are depreciating.

An index can be made up of hundreds to thousands of stocks. The average investor couldn’t afford to buy all of those stocks. Exchange-traded funds (ETFs) and mutual funds that follow an index can buy all those stocks because they have larger pools of money made up of the dollars of thousands of investors. When you buy even one share of an index fund, you own every stock in the index.

In addition, funds “weight” their purchases. This means they buy more of some stocks than others. This is because the index counts some stocks as more likely to affect the index than others. A good index fund will weight its purchases to the same degree the index does.

An index is much more likely to recover from a downturn than any individual stock. For example, an index fund tracking the S&P 500 in 2008 would have lost approximately 37%. However, that same index rose by 350% by the start of 2018. 

Does that mean that someone can guarantee the stock market will always recover? No one ever makes that claim. Here is what we can say: It always has recovered. That does not mean it always will, but knowing it always has provides some reassurance. However, a person with a short time horizon of, say, five years or less, could lose money in that time if the index drops. This is because that person can’t afford to wait several more years for it to recover. This is why index funds are best for long-term investors, those who intend to stay in the fund for 6-10 years or more.

Indexes such as the Dow Jones Industrial Average and the S&P 500 are designed to track the stock market in general. But, you can also invest in funds that track a sector, such as oil, technology, finance, consumer goods, and on and on. Whatever sector you can think of, someone has made an index for it, and someone else has created a fund that follows that index. An investor who thinks a particular sector is likely to outperform the general market can buy a fund that tracks that sector and still be diversified within the sector.

This leads to another way to diversify with index funds. When you invest in several sector funds, you may also be diversified. In other words, if your oil fund doesn’t do well, chances are another index fund will. So, not only are you diversified within each sector, but you are also diversified by having money in different sectors.

Make sure you know what each fund invests in so you don’t duplicate holdings. For example, investing in an oil fund would no doubt duplicate some of the stocks in an energy fund.

Professional money managers who run mutual funds study the markets daily and apply advanced skills and knowledge to their trades. Even with all that work, though, 80% don’t do as well as the market. If that many professionals get it wrong, an investor with less knowledge and time isn’t likely to beat the market either. An index fund will allow you to match the market’s returns without constantly trading and studying. This is the power of diversified investing through index funds.