Index Funds 101

All About This Investment Tool

Index Funds 101
October 16, 2015

If you are just getting started with investing, you can easily get lost in all of the technical terms thrown around in the investments space. However, you should make sure you know, at least, a little bit about what you invest in and how it works rather than simply ignoring the jargon. This is especially true for one of the better investment options for new investors, the index fund.

What Is an Index Fund?

Index funds are investments, usually in the form of a mutual fund or exchange-traded fund, which aim to mimic the returns of a particular index or group of investments. Rather than buying all of the individual investments included in an index and racking up a large amount of trading fees, you can buy the whole index with just one purchase of one fund. The fund will then change their investments whenever the index they track changes the core components of the index.

One example of an index fund is Vanguard 500 Index Fund Investor Shares (VFINX). This fund aims to mimic the S&P 500 and does so by buying the stocks of the 500 companies in the S&P 500 index. Whenever companies fall out of or join the S&P 500, VFINX will buy and sell the appropriate investments to match the new version of the index.

Why Index Funds Are Gaining Popularity

Fees, much like the return on your investment, will compound over your lifetime. Index funds have risen in popularity due to their generally low fee structure, which helps investors keep more of the money they earn from their investments.

In addition to low fees, index funds are considered a more passive investment. Since index funds aim to track an index, they do not look to buy the current hot stocks and ditch the current losers. Research has shown that the returns of index funds have often beaten the returns of similar actively managed funds after you account for the higher fees actively managed funds charge.

While an actively managed fund may have a few good years, investors do not know which funds will have break out returns or which years they will have them in. Index investors do not have to worry about hopping in and out as funds get hot and cool down.

What to Look out for in an Index Fund

Not all index funds are the same. Some may charge higher fees than others, yet provide a very similar product with similar returns. It makes sense to shop around for the best index fund that tracks the specific index in which you want to invest. Differences in fees can add up to tens or hundreds of thousands of dollars by the time you retire, so evaluate fees as one of the major deciding factors when choosing your investments.

Not understanding the details of your investments is another common trap many beginner investors fall into with index funds. While an index fund has a fancy name that normally sums up what they invest in, people fail to examine in what specifically the fund invests.

If you own multiple index funds, you could end up owning the same investments in multiple funds. You might think you properly diversified your portfolio by owning five index funds, but you could have ended up investing in five very similar stocks resulting in no real diversification at all. To prevent this from happening to you, look at the specific breakdown of investments in the prospectus of the index funds you already have purchased or are considering buying in the future.

Index funds can be a great investment as long as you know in what you are investing. Make sure you do the necessary research to maximize the odds of successful investing.

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Daniel | 10.16.15 @ 13:44
The more information you can get as you begin investing the better, taking time to learn things like this is a huge advantage.
Nancy | 10.16.15 @ 13:46
Index funds sound complicated. I think I would talk to a financial expert before I got involved.
Carla | 10.16.15 @ 13:46
Thank you for helping me better understand investing. It can be a bit overwhelming with all the information out here.
Angie | 10.16.15 @ 13:47
This makes me realize that I really do need to talk to my investing professional - dabbling without fully understanding all of the implications could be quite an expensive mistake.
Steffanie | 10.16.15 @ 13:47
Great information to start learning what an index fund really is.
Sarah | 10.16.15 @ 13:50
There sure is a lot to learn in the world of finances.
Debbie | 10.16.15 @ 13:51
Investing scares me all around. A financial advisor would have to seriously dumb this down for me to grasp it 100%
Erin | 10.16.15 @ 13:52
This is confusing to me. I'm really glad we have a financial expert to take care of these things for us.
trish | 10.16.15 @ 13:52
As good as this article is, I think i would still want to talk with an expert before making any decisions.
Amanda | 10.16.15 @ 13:54
I'm still lost with the investing and stocks stuff, but thank you for this information. I'll save it and use it as a reference.
STOKES | 10.16.15 @ 13:57
I have index funds but I let my financial advisor manage it. This is good information to help explain index funds.
Elaine | 10.16.15 @ 14:04
All of this lets me know how little I understand about investing. Sounds so complicated and might I say, scary!
Owen | 10.16.15 @ 14:06
Great information
Tina | 10.16.15 @ 14:07
Keep these posts coming - very informative.
Crystal | 10.16.15 @ 14:08
What great info! And easy to understand! Thanks!
irene | 10.16.15 @ 14:09
I've always been nervous about investing. Thanks for the great info
Bobbie | 10.16.15 @ 14:09
Lot of research before investing.
Jo Ann | 10.16.15 @ 14:09
Lots of good information. Looking at the diversification of funds is a great tip especially when buying more than one.
Zanna | 10.16.15 @ 14:19
Thanks, this is helpful info for someone like me, I'm still learning all the terminology!
Christina | 10.16.15 @ 14:30
There is a lot to understand before investing. It seems like a huge gamble with money. Thanks for the info.
Alec | 10.16.15 @ 14:40
I'm not clear on some of the details but it seems like an index fund, being more passive than aggressive, would suit me better provided a financial advisor helped me understand the pros and cons for me specifically for whatever I wanted to invest in and if it was the best choice. Fewer fees always sounds better unless I'm losing money.
Heather | 10.16.15 @ 14:55
I had no idea what index funds were before now. This just gives me one more thing to talk to my financial advisor about.
$commenter.renderDisplayableName() | 05.18.21 @ 08:15