You may have heard that you can simplify your investment strategy just by owning index- based or passive investments. But is this a good idea? You’ll want to consider the different aspects of this type of investment style.
To begin with, an index- based investment is a vehicle such as a mutual fund or an exchange- traded fund (ETF) that mimics the performance of a market benchmark, or index — the Dow Jones Industrial Average, the S&P 500, and so on. (An ETF is similar to a mutual fund in that it holds a variety of investments but differs in that it is traded like a common stock.) You can also invest in index funds that track the bond market.
Index investing does offer some benefits. Most notably, it’s a buyand-hold strategy, which is typically more effective than a market-timing approach, in which individuals try to buy investments when their prices are down and sell them when the prices rise. Attempts to time the market this way are usually futile because nobody can really predict when high and low points will be reached. Plus, the very act of constantly buying and selling investments can generate commissions and fees, which can lower your overall rate of return. Thus, index investing generally involves lower fees and is considered more tax efficient than a more active investing style.
