Index Funds 101 - All About This Investment Tool

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.