What Is an Index Fund?


If you’re learning about the investing world, you might come across the term ‘index funds’ as they are a trendy way to invest these days.

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Investing powerhouses like Warren Buffett and Tony Robbins wholeheartedly recommend investing in index funds. In fact, LeBron James recently asked Buffet for investing advice on CNBC, and Buffett said James couldn’t go wrong with investing in them for 30 or 40 years.

What is an index fund, and how does it work?

Starting with the basics, an index fund is a type of mutual fund. A mutual fund is a portfolio of numerous stocks, bonds, and other securities. So, instead of buying a single Apple stock, you can buy a tech-focused mutual fund with a portfolio of several tech company shares, not just one. Index funds can help to spread out the risk and make a more conservative investment.

Are mutual funds and index funds the same?

All index funds are mutual funds, but not all mutual funds are index funds. Since an index fund is a type of mutual fund, it’s also a portfolio of numerous companies. However, the difference is that index funds mimic a stock index, while actively managed mutual funds consist of stocks picked by fund managers with the goal of beating the market’s performance.

Most actively managed funds have higher costs than index funds, but that’s not always the case. Some of the most well-known indexes are:

  • Dow Jones Industrial Average
  • S&P 500
  • Nasdaq
  • Russell 3000

What is the Dow Jones Industrial Average?

The Dow Jones is a stock market index that measures how well the 30 largest publicly traded U.S. companies perform. It includes household names like Nike, Walmart, Pfizer, Coca-Cola, Walt Disney, and more.

What is the S&P 500?

The S&P 500 is an index that measures the top 500 companies in the U.S. Because it includes so many companies, this index is exceptionally diverse. It helps investors look at the strength of the market as a whole on any given day.

What is the Nasdaq Composite Index?

This index represents over 3,300 companies listed on the NASDAQ stock exchange. Technology companies make up a large portion of the NASDAQ.

What is the Russell 3000?

This index tracks the 3,000 largest publicly traded companies in the United States. There is also the Russell 2000 index and the Russell 1000 index.

So, if it’s an S&P 500 index fund, that means it should perform close to how the S&P 500 index performs. It likely does not have every single company in the S&P 500 in its portfolio. However, it has just the right mixture of companies and weights them in a way that the fund’s performance mimics the performance of the total index.

To put it another way, if the S&P 500 is reporting gains in a particular week, an S&P 500 index fund should also be experiencing gains in the same week.

What is the average rate of return on index funds?

There are many index funds, so it’s impossible to list the rate of return as a whole. You can research the history of a particular index fund to see the returns in a specific year. However, it’s more beneficial to look at returns over the long term.

Historically, the market as a whole averages from 7-10% in returns. Some years, like during the 2008-2009 recession, show terrible returns, while others show spectacular returns.

Can you lose money with an index fund?

Yes. When you buy an index fund, you’re investing in the stock market. The market is unpredictable. You could lose money one day and earn money the next. Either way, financial experts still point to index funds as a good investment option as they usually have substantial long-term returns and low expense ratios.

What is the best index fund?

Please note: These are not recommendations. It’s simply a list of several popular index funds.

There are many top-rated index funds. Of course, the best one depends on the timeframe in which one measures it. However, there are some that have shown a strong rate of return with low fees. Here are some examples:

  • Schwab S&P 500 Index Fund
  • Fidelity Spartan 500 Index Investor Shares
  • Vanguard 500 Index Fund Investor Shares
  • Vanguard Total Stock Market Index
  • Fidelity Total Stock Market Index

Again, no one knows which funds will perform the best in any given year. However, some of the companies listed above are known for low fees and solid financial products. Take your time to research the best brokerage company for you. Some require very little money to start investing, while others might require a lot more.

How do I invest in index funds?

Ready to invest? Follow the steps below.

  • Step 1: Choose a brokerage firm. There are many highly rated, popular brokerage firms that offer their own branded index funds. Fidelity, Vanguard, and Charles Schwab are three of the most popular brokerage companies.
  • Step 2: Decide which index you want to follow. The largest brokerage firms should have many options. You need to decide if you want an index fund that just follows the S&P 500, the entire U.S. market as a whole, or something else.
  • Step 3: Ask about fees and other potentially hidden costs. The quickest way to reduce your overall return is to pay high fees. Index funds are known for having low fees, but you still need to know what they are and how they will impact your overall returns.
  • Step 4: Once you’ve picked a brokerage firm, try to invest for the long term to take advantage of historic average returns and compounding interest.

How do you make money from an index fund?

You make money by earning returns. So, if you invest in an S&P 500 fund and the U.S. economy is doing well, your index fund shares might grow to be worth more. You can make money by selling your index funds and keeping your profits. Certain index funds also pay dividends. You can also invest in the long term and watch your money grow due to the effects of compounding interest.

Final Thoughts

Many financial experts, like Warren Buffett, highly recommend index funds as a way to invest. Index funds offer the advantage of being liquid assets, and it may not require a significant amount of money to begin investing in them. Furthermore, as mentioned previously, they typically have low fees.

Index funds are also a conservative way to invest. Because they follow indices made up of many companies, you spread out the risk. If one company in the index has a terrible week, chances are there’s another company doing well enough to balance it out. When you invest in individual stocks with just one company, you don’t have that cushion if a company starts to do poorly.

Of course, as with any investment decision, do your research. Learn as much as you can about index funds and the costs associated with buying one before investing your own money.

Catherine Alford
Meet the author

Catherine Alford is the go-to personal finance expert for educated, aspirational moms who want to recapture their life passions, earn more, reach their goals, and take on a more active financial role in their families.