What is an Index Fund and Should I Invest in Them?
Updated: Jun 19, 2019
When it comes to investing inside of your retirement and non-qualified accounts, it is no secret that I am a big fan of using index funds. An index fund is a fund that was created to “replicate” or “match” the performance of a specific index of stocks, bonds or other types of investments like oil or the US dollar . The most common example is the S&P 500 index fund. Investors purchase this fund with the expectation that the performance will match the performance of the S&P 500 index. That means you can turn on CNBC to see how the S&P 500 is performing and know immediately how your account is doing. There are no big surprises. You do not need to worry if your ‘fund manager” picked the right stocks or is taking too big a gamble on a company that does not work out.
Index funds have become so popular that there are now tons of them tied to every index you can think of. There are gold index funds, energy index funds, internet stocks index funds, emerging market index funds, Europe index funds, and so on and so on. Most employer sponsored retirement plans like a 401k will only have a few of these options available mixed in with other “actively managed funds”. It is very important to understand the differences (especially in cost) and choose the option that is right for you.
Here are the few simple reasons why I almost always recommend index funds:
Low Cost - Cost matters big time! More than people realize. It makes a huge impact on your bottom line. It is also the one variable that we as investors can control. Index Funds are not “actively managed” by a “fund manager”, they are instead “passive funds” that move with the index they are replicating, this results in a lower cost. Most active funds have much higher fees and rarely perform better than the corresponding index fund.
Simplicity - Buying an index fund can be easy to understand and easy to track. Investing in things you have no control over and do not understand is never a good idea.
Diversification - It is very hard to pick winners and losers, even for “professional” fund managers. You can create a portfolio of a few index funds and be in great shape for a very long time. It is an easy yet efficient way to save for your goals. Index funds allow access to own the entire market or to add additional exposure to small sectors.
Who invests in Index Funds?
Index funds are used by large pension funds, endowment funds, hedge funds, 401k plans and individual investors. They are for everyone. My entire “stock market based” retirement account portfolio is made up of low cost index funds.
There is always risk with investing
Just remember index funds are investments and carry risk. The risks vary greatly depending on what index you are replicating. For example a fund replicating small companies in India is going to carry much more investment risk than a fund replicating short term US government bonds.
Let me know in the comments below if you are currently using index funds or actively managed funds in your investment accounts. Also, if you have any questions when it comes to the thousands of funds available you can always shoot me an email at firstname.lastname@example.org and I will give you my 2 cents.
To becoming great with money....
Rich McCormack, CFP®
School of Personal Finance