One of the key advantages of an index fund is that you immediately have a range of stocks in the fund. For example, if you own a broadly diversified fund based on the S&P 500, you’ll own stocks in hundreds of companies across many different industries. But you could also buy a narrowly diversified fund focused on one or two industries.
Diversification is important because it reduces the risk of any one stock in the portfolio hurting the overall performance very much, and that actually improves your overall returns. In contrast, if you’re buying only one individual stock, you really do have all your eggs in one basket.
The easiest way to create a broad portfolio is by buying an ETF or a mutual fund. The products have diversification built into them, and you don’t have to do any analysis of the companies held in the index fund.
“It may not be the most exciting, but it’s a great way to start,” Keady says. “And again, it gets you out of thinking that you’re gonna be so smart, that you’re going to be able to pick the stocks that are going to go up, won’t go down and know when to get in and out of them.”
When it comes to diversification, that doesn’t just mean many different stocks. It also means investments that are spread among different asset classes – since stock in similar sectors may move in a similar direction for the same reason.