By Mack Bekeza

Although index funds can be an excellent choice for retirement investing, many people do not have a complete understanding of how they work. Before we get into the main topic, let’s get some facts straight about what these funds have done historically.

  1. Over the long term, have index funds outperformed the large majority of their active cohorts? Yes!
  2. Are index funds a much cheaper way to invest than actively managed funds? Yes!
  3. So, just because someone is only invested in index funds, have they significantly reduced their portfolio risk? Well… not exactly.

Being able to understand the risk of an index fund has been difficult for some investors, simply because they do not have a complete understanding of what they are invested in. For instance, a study conducted by Natixis, found that 64% of investors believe that index funds will help minimize investment losses. Natixis also found that nearly 7 out of 10 investors believe that index funds “provide the same access to the best investment opportunities in the market.”[1] Is this true? Again…not exactly. So, how can investors reduce investment losses with index funds? The simple answer is through diversification.

Diversification, or what is known to academics as the only free lunch in investing, is simply investing across different asset classes (stocks, bonds, cash, etc.) and across numerous regions around the world (i.e. domestic funds and international funds). As a result, investors reduce risk by having funds that do not all go up and down together. For example, let’s take a $1,000 portfolio that has 50% invested in a stock index fund and 50% invested in a bond index fund. If the stock index fund loses 2% in one year and the bond index fund gains 4%, the portfolio has increased by 1%.

So why doesn’t the portfolio go up 2% if it has a 50/50 split between stocks and bonds? Well… let’s find out. At the end of the year, the $500 that was in the stock fund turned into $490 and the $500 in the bond fund turned into $520. If we add them together, the portfolio is now worth $1,010, a 1% gain. Diversification is meant to be used to reduce risk and stabilize the portfolio. And, if you diversify with index funds, you have found a way reduce risk while saving money!

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[1] Here is the article about the study: http://www.planadviser.com/Investors-Miss-Much-of-the-Subtlety-in–Active-vs-Passive-/