Everyday Financial Guide

January 9, 2012

How Indexed Investments Work

An indexed investment is designed to give average people a simple automatic investment that limits risks while maximizing gains. Essentially an index is a lazy man’s investment, the investment itself is supposed to manage risks and move with the economy. All the investor has to do is sit back and watch his money grow.

These tools are based on a powerful investment strategy called indexing. Indexing is basically a risk management tool that has a side benefit of maximizing gains if it is used properly.

Indexes Explained

An index is nothing but a list of stocks. An indexed mutual fund or exchange traded fund is a trading company that buys a number of shares of every stock on the list.

Indexes can be based on anything you could have an index of all companies with names beginning with P. Some indexes track an economy or market, S&P 500 indexes try to track the entire US economy by owning stock in the 500 largest companies in the US. Other indexes will follow an industry such as gold mining or a foreign country’s economy.

The idea behind this is to reduce risk by holding many different stocks the investors will be less likely to lose money if one company fails. They are also supposed to protect investors against economic downturns. An S&P 500 index would presumably include stocks in companies performing well under current economic conditions. It would also own stocks that would increase in value with the economy.

If the overall market fell but pharmaceutical stocks did well, an S&P 500 index would make some money because it would presumably own pharmaceutical stocks.

Drawbacks to Indexed Investments

An indexed investment gives you little or no control over how the money is spent. Hands on investors may not like this. Other people may object to the strategy because the index might contain stocks in companies they would object to. A pacifist might object to holding stock in a weapons company.

Another problem is that index funds can be very vulnerable to bull markets. If the market loses value the fund will. A large market sell off can significantly lower an index’s value.

An index is a long term investment tool that will only work if funds are left in for a long time. If you plan to take the money out quickly the gains from indexing will not be realized. That is why an indexed investment is ideal for retirement but not for short term savings.

Advantages to Indexed Investments

A big advantage to an indexed product is that you have to pay little or no attention to it. The fund’s managers will decide what to buy and when to buy. This can limit risks even if it makes the investing rather dull.

An S&P 100 fund would only invest in companies of a certain size. That would provide a certain level of safety because it the companies are proven money makers with considerable assets. It would avoid smaller newer firms that are riskier. It would also only buy into a company when it was a success or at a certain size.

This allows a person to invest in all the businesses that are performing well. It also avoids speculation and encourages disciplined investment.

A final advantage to indexed investing is that there some insured indexed products available. Some of these including indexed annuities are designed to lock in market gains. They have an insured rate of return that matches the highest index gain.

Steven Hart is a freelance writer and a Financial Advisor from Cary, IL. He writes about Annuity topics like Ordinary Annuity, Retirement Annuity, and Income Annuity.

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