While building an investment portfolio, it is essential to understand the key difference between various asset classes. Take, for example, an individual stock and index fund. A stock gives an investor one share of ownership in a single company.
On the other hand, an index fund is a portfolio of assets. Generally, this includes shares in several companies, including bonds and other asset classes. The portfolio is designed in such a way to track entire sections of the market, rising and falling as those segments do.
The first thing that divides individual stocks from index funds is the high volatility factor. If the chances of making profits are high in stocks when the market is high, then there is an equal possibility of a low leading to losses.
Index funds, meanwhile, have a diversified nature, which means that there are fewer phases of peaks and troughs. Similar to the lines of other fund-based products, an index fund holds an array of assets in its overall portfolio. In this case, an investor is investing several of the stocks, bonds, or other asset classes, this is unlike in an individual stock.
This ensures that even if one company loses value, there is usually another company to make up for low performance. Similarly, if one company garners considerable gains, such returns would be watered down by the overall portfolio as a whole.
The diversification of an index fund is proportional to the nature of the fund itself. For instance, a fund that invests in a particular industry or market sector will be less diverse as compared to a fund that invests in the market as a whole. An industry may witness a dip or surge more easily than the whole market can slip into a recession or boom.
Rajiv is an independent editorial consultant for the last decade. Prior to this, he worked as a full-time journalist associated with various prominent print media houses. In his spare time, he loves to paint on canvas.