Lots of people buy “index funds,” a type of mutual fund with components that track a segment of the market (like the Dow Jones Industrial Average, the price of gold, or even a specific country’s stock exchange).
Many people, too, often benchmark their own returns against the popular indices. Index funds are popular investments since they provide broad market exposure with relatively low management costs.
A common mistake
When some investors purchase an index fund, such as the S&P 500, they erroneously believe that their investment is divided equally among 500 stocks because the index is comprised of 500 companies. This is not actually the case, though, because the S&P 500 is a “capitalization-weighted” index. This means that the larger companies have a proportionally larger share in the index than smaller companies. Indeed, about three quarters of the S&P 500 index’s return could be attributed to the top 50 or 75 stocks! In other words, the performance of fewer than 20% of the stocks in the list will have a major influence on your return.
You may decide that equal-weighted funds are more suitable for you. In this case, you may want to purchase an equal-weighted ETF or even an actively managed mutual fund in which the underlying stocks are equally balanced.
Make an informed decision
I’m not making a specific recommendation to buy any particular index fund or mutual fund. But if you are considering whether to buy (and especially if you already own) an index fund, make sure you know exactly what’s going on. While an index fund may be a good way to gain diversification and maximize potential growth in your portfolio, it is important that any index fund you own fits into your ideal asset allocation model.
If you are wondering whether having a diversified portfolio really matters, read this: Profile-Financial.com/why-diversify
Douglas Goldstein, CFP®, is the Director of Profile Investment Service, Ltd., which specializes in helping people who live in Israel with their US dollar assets and American investment and retirement accounts. He helps olim meet their financial goals through asset allocation, financial planning, and using money managers.
Published February 8, 2016. Updated December 2022