The Importance of Index Trading: A Key Component of a Diverse Portfolio

The Importance of Index Trading - A Key Component of a Diverse Portfolio

Diversification and low costs are two of the main selling points of index funds. When you invest in an index fund, you have exposure to all the stocks that make up an index. In theory, rising stock prices would balance out those of falling ones.

Here, we take a closer look at how index trading is a key component of a healthy, diverse portfolio. 

Why index trading can be better than investing in individual stocks

An index can consist of hundreds or thousands of stocks. The average investor would be unable to purchase all of those stocks. Because they have larger pools of money made up of the dollars of thousands of investors, exchange-traded funds (ETFs) and mutual funds that track an index can buy all of those stocks. When trading indices you own every stock in the index if you buy even one share of an index fund.

Funds “weight” their acquisitions as well. Thus, some equities are purchased more frequently than others. This is so that the index can account for stocks that are more likely than others to have an impact on the index. An effective index fund will weight its acquisitions similarly to the index.

In comparison to any one stock, an index has a significantly higher chance of recovering from a decline.

Does that imply that a person can assure a stock market recovery every time? Nobody ever asserts that. What we can say is that it always bounces back. 

Even though there is no guarantee that an index fund will always survive every downturn, the knowledge that index funds have an historical tendency to bounce back offers some comfort. 

However, if the index declines, a person with a short time horizon—let’s say, five years or less—could lose money during that period. That’s because they can’t afford to wait for it to recover for a few more years. This is why long-term investors, or those who want to hold a fund for six to ten years or longer, should choose index funds.

Index sectors for diversification

The S&P 500 and the Dow Jones Industrial Average are two indexes that are used to track the overall stock market. You can, however, also invest in funds that follow specific industries, such as those in the energy, technology, banking, consumer goods, and so forth. 

Any industry you can think of has an index for it, and a fund that tracks that index has also been formed. An investor can purchase a fund that tracks a sector they believe will beat the overall market while remaining diversified within that industry.

This suggests an additional method for diversifying with index funds. Additionally, you can be diversified if you invest in a variety of sector funds. In other words, odds are that another index fund will perform well if your oil fund doesn’t. Therefore, you are diversified not only within each area, but also by investing money in many sectors.

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