What is an Index Fund? Index Funds Explained for New Investors (2024)

FAQs

What is an Index Fund? Index Funds Explained for New Investors? ›

Index funds are investment funds that follow a benchmark index, such as the S&P 500 or the Nasdaq 100. When you put money in an index fund, that cash is then used to invest in all the companies that make up the particular index, which gives you a more diverse portfolio than if you were buying individual stocks.

An index fund is a group of stocks that aims to mirror the performance of an existing stock market index, such as the Standard & Poor's 500 index. An index is made up of companies that represent a part of the financial market and offers a look into the health of the economy as a whole.

Index funds are popular with investors because they promise ownership of a wide variety of stocks, greater diversification and lower risk – usually all at a low cost. That's why many investors, especially beginners, find index funds to be superior investments to individual stocks.

Index funds involve passive investing, using a long-term strategy without actively picking securities or timing the market. Index funds should match the risk and return of the market based on the theory that, in the long term, the market will outperform any single investment.

The benefits of index investing include low cost, requires little financial knowledge, convenience, and provides diversification. Disadvantages include the lack of downside protection, no choice in index composition, and it cannot beat the market (by definition).

How can I directly invest in index funds? You can directly invest in index funds by opening and funding a brokerage account. All brokers allow you to directly buy shares of ETFs on the open market, and most allow you to directly invest in mutual funds if you prefer to use those.

As with other mutual funds, when you buy shares in an index fund you're pooling your money with other investors. The pool of money is used to purchase a portfolio of assets that duplicates the performance of the target index. Dividends, interest and capital gains are paid out to investors regularly.

Lack of Downside Protection

Investing in an index fund, such as one that tracks the S&P 500, will give you the upside when the market is doing well, but also leaves you completely vulnerable to the downside.

According to Standard and Poor's, the average annualized return of the S&P index, which later became the S&P 500, from 1926 to 2020 was 10%. 1 At 10%, you could double your initial investment every seven years (72 divided by 10).

However, like all speculative assets, you should make sure that individual stocks only make up the speculative part of your portfolio. Invest in these assets with money you can afford to lose. For the long-term, stable segment of your portfolio, index funds are often an excellent idea.

Why does Warren Buffett like index funds? ›

Buffett not only sees index funds as the simplest path to achieve a diversified portfolio, but they're also the cheapest.

Investing in individual stock gives you partial ownership of a company. Index investing also gives you partial ownership in companies, but you'll have to look up the fund's portfolio to learn what you own (and in what proportion to your total ETF position).

Are there dividend-paying index funds? Yes, there are several dividend-paying index funds for investors who prioritize steady income over high growth.

In fact, a number of billionaire investors count S&P 500 index funds among their top holdings. Among those are Buffett's Berkshire Hathaway, Dalio's Bridgewater, and Griffin's Citadel.

That's because your investment gives you access to the broad stock market. Meanwhile, if you only invest in S&P 500 ETFs, you won't beat the broad market. Rather, you can expect your portfolio's performance to be in line with that of the broad market. But that's not necessarily a bad thing.

The important thing to remember about index funds is that they should be long-term holds. This means that a short-term recession should not affect your investments.

Most index funds pay dividends to their shareholders. Since the index fund tracks a specific index in the market (like the S&P 500), the index fund will also contain a proportionate amount of investments in stocks. For index funds that distribute dividends, many pay them out quarterly or annually.

Dividend index funds can be mutual funds or exchange-traded funds (ETFs). Investors can select an index that includes multiple dividend-paying stocks. They generally provide steady income instead of high growth.

Index funds are a low-cost way to invest, provide better returns than most fund managers, and help investors to achieve their goals more consistently. On the other hand, many indexes put too much weight on large-cap stocks and lack the flexibility of managed funds.

Small chance of big short-term gain: As investment tools designed for tracking market indices, index funds have minimal potential for achieving substantial short-term gains. Investors aiming for notable short-term profits should temper their expectations when opting for this investment strategy.