Do you think stock market investing is all about spending lots of time reading up on stocks, analysing technical indicators and keeping abreast of market-moving events? And is that putting you off taking your first step? If so, an index fund (also known as an index tracker) could be a great idea for your portfolio. Indeed, it can even contribute towards early retirement.
What are index funds?
Simply put, an index fund is a financial product you can buy that mimics the performance of a financial index (the clue’s in the name!) This is sometimes why index funds are known as trackers. It wouldn’t make sense for someone to mimic the performance of one stock — these funds copy the performance of a group of stocks such as the well-known stock market indices.
For the purpose of this article, I will be focusing on a FTSE 100 index fund. Yet it is useful to know that an index fund in theory can track a vast variety of different groups of stocks. It could echo the NASDAQ index in America, or the healthcare sector in Japan, for instance.
What is the point of an index fund?
An index fund allows you to track the performance of something that otherwise would be hard for you to replicate yourself. The FTSE 100, logically, has 100 firms within it at any point in time. It would take you an awfully long time (and a lot of cash) to buy 100 separate stocks. Instead, you can simply buy one index tracker based on the FTSE 100 and track the performance of the 100 firms.
I should note that the index fund will have some margin of error that you need to take into account. This is known as the tracking error and arises for various reasons (most beyond the scope of this article). Sometimes the funds don’t actually own the 100 stocks themselves but the fund managers use financial derivatives to gain exposure to companies. Regardless of that, an index fund is a reliable, affordable, one stop shop for an investor looking to gain access to the index performance.
How can they help me to retire early?
Index funds sum up the ‘buy-and-hold’ philosophy we have at the Motley Fool. They’re designed to offer steady returns and therefore to be held for a long time. They may rise or fall, but over time, the performance is smoothed out and historically speaking, has been positive.
Secondly, they’re cheaper than buying and selling all the individual stock names yourself. They also save you the time of researching all the companies within the index, allowing you to spend your time earning money from pursuing other income opportunities.
And if you reinvest your dividends in the fund, you can benefit from compounding as your interest earns interest and help you towards your retirement goals.
For newcomers, FTSE 100 index funds may seem like complex products, but instead they’re actually rather simple tools enabling you to potentially grow your wealth.
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Jonathan Smith and The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.