Difference Between Mutual Funds and Index Funds
May 15, 2021
When it comes to stock market investing, there are many different ways you can make money. For some people, investing in individual equities can be very rewarding if they can do the proper research.
However, for most people, when it comes to retirement or stashing away funds long-term, the preferred method is to invest in a diversified fund, sometimes referred to as index funds and mutual funds.
For many people, these two terms may seem interchangeable, but they are in fact inherently different. The main way to sum it up is that index funds try to mimic the market while mutual funds try to beat the market.
While mutual funds might seem like the obvious way to go, it is often considered risky because fund managers can’t always predict the movement of stock prices. This means that depending on the environment and their performance, they may at times underperform an index fund.
How to Understand Market Terms like Index and Indicators?
In the market, there are a lot of what are called indexes, which are indicators of a market or sector performance. Some popular examples are the Dow Industrial Index, the S&P 500, and the NASDAQ-100.
The Dow and NASDAQ focus on specific sectors of the market which at times can work against each other since the DOW focuses on industrial companies that thrive in a healthy stable economy, while the NASDAQ tends to focus on technology and will always perform better during economic market uncertainty.
The S&P 500 is considered a broad index that focuses on 500 of the largest publicly-traded companies in the United States. Many beginner investors are encouraged to put their initial funds into an S&P 500 index fund as the basis for their portfolio.
Important Things you need to know about Mutual Funds:
Mutual funds are a lot more aggressive as they may not be sector-specific, and may do research to pick certain company names out of an index fund that they believe will outperform their counterparts.
This involves a mix of fundamental analysis and technical analysis to identify appropriate entry points and valuations to open or close positions. Fund managers have a lot of experience in understanding the ins and outs of the market, such as rotations, pullbacks, and how do insider trading works.
Index funds and mutual funds both have fund managers, but as stated, their roles in terms of portfolio balance are different. When new investors pour funds into an index fund, it’s imperative that fund managers allocate that capital to preserve the mimicking of the index they are trying to follow.
Although they can modify weights a little bit here and there, ultimately, they need to stay in general consistency with the index fund. Some funds might decide to be invested in the same companies as an index but may decide to weigh them differently. This is referred to as a weighted index fund.
Retirement Portfolios: How do they work?
When it comes to both index funds and mutual funds, you will find that in many cases they are utilized for retirement portfolios. However, even if money was not allocated for retirement per se, it is still recommended that you take a long-term view with these funds and only pull out for emergencies.
Given market volatility, you may want to have at least a five-year horizon to ensure that all the funds invested to generate a meaningful return.
Mutual funds can also be tailored to certain strategies you are trying to achieve in the market based on levels of risk and the type of returns you are trying to generate. It is always imperative to do your own research to find a fund that matches these goals.
Some mutual funds focus on dividends, by being invested in dividend stocks, and redistributing that dividend to shareholders. Typically, dividend stocks are less volatile and so many investors who prefer a patient long-term view or are looking to live off dividend income may utilize these types of funds.
The Bottom Line:
Other funds, on the other hand, can be a focus on very speculative stocks that carry high risk, but may also achieve high rewards. It’s important as a beginner to not overthink and find a mutual fund you are comfortable with. Overall, there are pros and cons to whether you invest in index funds or mutual funds, so be sure to do your research first.
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