The idea that low-cost index funds are only popular among investors with low risk appetite is outdated. In 2024, even investors with high risk appetite prefer to park a fraction of their capital in these investment vehicles. 

And why shouldn’t they? Markets around the world are volatile now. The CBOE Vix is currently standing at 15 with the 52 week range hovering between 11 and 24. Interestingly, the way the US financial market has been behaving for the last few years, a low Vix environment doesn’t necessarily imply stability and the absence of erratic fluctuations, as indexes have defied traditional norms quite a few times in the past and witnessed rapid surges even when there were no positive clues.

Hedge Against Volatility?

Low-cost index funds come with a plethora of benefits. However, these are not perfect hedges against volatility. 

Why then, risk-averse investors have historically preferred them?

One reason is inflation affecting pensions and savings. Also, low-cost index funds align well with their risk tolerance. Even though low-cost index funds are susceptible to volatility as their returns are inherently tied to the performance of respective indexes, diversification across various holdings within an index can reduce some risks compared to a single stock. Because index funds hold a basket of stocks within an index, the diversification reduces potential risks coming from a single company performing poorly.

In case of global market meltdowns, the likes of which the world has seen during the 2008 housing market crash or the March 2020 stock market crash, low-cost index funds are expected to tank. In such scenarios, investors can either exit as soon as they can and re-enter only when the index is historically low, or hold on to the investment for as long as they can. 

Both decisions can yield great returns for them if they have the patience to wait. But the level of risk tolerance determines the gap between these returns. Hence, low-cost index funds cannot mitigate losses arising from a disastrous market collapse, but  they can be strategically used during downturns to potentially benefit investors who check all the boxes – patience, discipline, and a long-term investment horizon.

A Few Other Benefits

Passive management is the biggest benefit of low-cost index funds. Unlike actively managed funds that employ qualified people to pick stocks, low-cost index funds simply mirror the composition of an index. This is accompanied by lower commission and costs compared to an actively managed fund. Such fees are termed ‘expense ratios’ representing as little as 0.02% for certain index funds.

For long-term investments, low-cost index funds are the most suitable option because individual stocks could plummet to the bottom, and then never recover again. But index funds – due to their diversified nature – always recover and come back stronger. That’s why they are a good fit for those who are long-term oriented and are likely to hold their investments for over five years.

Lower expense ratio – as mentioned before – is yet another benefit of low-cost index funds. Let’s understand how a small expense ratio impacts index fund returns over time. Let’s assume an index fund carries a fee of 0.10%, while another index fund has a 0.20% brokerage fee. Now, if you invest $10000 into each one, the second one will cost you $20 more.

For the example presented, assume both the funds had a matching annual return of 10% from the initial investment capital of $10000. The first fund will give you a return of $990, ($10000 x 10% = $1000; $1000 – ($10000 x 0.10%). The 0.20% expense ratio fund will be able to yield 9.8% after the owner deducts the expense ratio from the profit made ($10000 x 10% = $1000; $1000 – ($10000 x 0.20%) = $980). A 0.1% differential may appear small, however, it may grow significantly as time goes by, especially for long-term investors.

Choosing the Right Fund

There are hundreds of index funds out there – both high-cost and low-cost. You must choose the one that’s right for you. To identify the right one, consider your investment goals and your risk appetite. Broad market index funds that track S&P500 or NASDAQ can give you access to greater diversification, but these funds are comparatively more vulnerable to volatility. 

If you think you have the mental fortitude to take risks, go for these funds. Time-horizon is crucial to reduce systemic risks. Your portfolio might be in all red in case of a global crash; what you do afterwards is important. Would you sell or continue to hold? This is where risk tolerance comes into the play.

Some Additional Considerations 

Take time to think about whether a taxable account or a retirement account (like 401(k) or IRA) is the right place for investment. The tax implications might also be determined by the nature of the account.

Some platforms offer the option of creating automatic deposits into the fund at regular terms. This is a good move to invest regularly and have a chance to observe the successful dollar-cost averaging process (which is buying more shares when the price is low and fewer shares when the price is high).

Within an index fund, the positioning and weightage of individual stocks might change over time, and sometimes, you may not like the change. Carefully observe such changes and assess how they impact your portfolio.

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