Index Funds

We talked earlier this week about mutual funds. Historically mutual funds allowed us to pick a fund manager and have him manage our funds, as well as other investors', in a large pool. In recent years however, a different kind of mutual fund has become very popular, the index fund.

What is an Index Fund?

Unlike a typical mutual fund where the holdings can shift around, the stocks in the index fund are set to change based upon the information drawn from a stock market index (like the S&P 500). The index fund is passively managed, which means that little or no human input is needed to adjust the fund’s stocks – a computer controls the moves as the index changes.

What's Good About That?

Over time, it became painfully clear that many mutual fund managers weren't even matching the returns generated by the stock market itself. The stock market would increase by an average of 11% per year, while many mutual funds generated less than that. Why were investors paying fund managers to under-perform the market?

Index funds take out the research of investing in mutual funds. Rather than have to figure out which fund managers are any good, you simply choose to match the markets. In addition to maintaining a return similar to the index as a whole, your index fund will have very few fees, since it is managed by a computer rather than a person. Since many indexes are made up of large and more stable companies, these funds have a tendency to be a bit more stable as well.

Negatives of an Index Fund

On the downside, index funds can never return more than the index returns. You're basically shooting to be average, which doesn't appeal to some investors. However, matching the market is often difficult to do and while it may not sound exciting, solid investments aren't always exciting.

Index funds can provide a convenient way for an investor to get a reasonable return without having to spend an inordinate amount of time researching. Over the long-haul, matching the overall stock market returns has been a solid strategy for building wealth; don't rule it out simply because it sounds rather boring. Wealth isn't built in a day.

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Anonymous's picture

MoneyCone wrote:

Sat, 01/01/2011 - 02:36 Comment #: 1

Very well explained Christa! To put this into perspective, the S&P grew over 12% this year. If you had invested in an index fund that tracked the S&P500, you'd have gotten 12% which is waay higher than any CD!

Not to say this can't go down, but then that's the risk you take which is still less than investing in a single company. S&P 500 cannot go to zero. Today's stars like GOOG or AAPL can! Who would've thought Palm would die 13 years back!

Anonymous's picture

kevin cimring wrote:

Sat, 01/01/2011 - 02:39 Comment #: 2

Excellent summary Christa! Here's wishing you a happy, healthy and prosperous New Year!

Anonymous's picture

Daddy Paul wrote:

Sun, 01/02/2011 - 03:15 Comment #: 3

Well explained. In most 401K's an index fund is the best choice. In an IRA I like to choose the best mutual funds.

Christa Palm's picture

Christa Palm wrote:

Mon, 01/03/2011 - 19:04 Comment #: 4

Moneycone, great clarification! BTW, I never thought Palm would die out, either -- surprises around every investment corner!

Kevin, thank you! I hope your New Year's was fantastic -- wishing you all the best in 2011!

Daddy Paul, welcome and thanks for the tip!

Anonymous's picture

Invest It Wisely wrote:

Tue, 01/04/2011 - 04:12 Comment #: 5

Matching the market returns isn't such a bad thing. I do wonder what would happen should more and more money continue to pile into passive indexes.

Christa Palm's picture

Christa Palm wrote:

Wed, 01/05/2011 - 20:23 Comment #: 6

Great point, Invest It Wisely -- what would happen to all the brokers?

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