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What is an Index Fund?

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  • Originally Written By: Bryan Pedersen
  • Revised By: Bott
  • Edited By: Lindsay D.
  • Last Modified Date: 24 August 2016
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For those interested in getting the same results as the stock market in the last century without the hassle of choosing individual stocks, there are index funds. Over the last century, the market has shown a general incline in value, even with the cost of recessions and depressions factored in. Anyone who consistently invested over the years should be handsomely rewarded in the long run, considering they don't cash out during an economic crisis or recession. The stock market is made up of thousands of individual stocks that have both gone up and down, and choosing the right stocks isn't an easy task; an index fund simplifies this process by allowing for investment in the index as a whole.

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Stock Market Index

This type of fund matches the movement of one stock market index, of which there are over 1,000 to choose from. Two of the most common indexes cited when determining whether the market is up or down on that particular day are the Dow Jones Industrial Index and the NASDAQ Composite Index, originally known as the National Association of Securities Dealers Automated Quotations. The Dow Jones is made up of 30 of the largest and most established companies, such as American Express, Kraft Foods, Microsoft, and Wal-Mart, and was created over 100 years ago, while the NASDAQ is an electronic stock exchange and generally a haven for fast-moving technology stocks. The S&P 500 is another index that is often cited and has available index fund shares.

How it Works

To match a stock market index, each fund share is made up of a proportional amount of stock from each of the companies within the index it matches. An index fund also differs from mutual funds in that they aren't managed; they blindly follow the index, for better or for worse. The formula determines which stocks to buy, whereas a mutual fund is actively managed by a money manager who decides how much of each stock to buy. An index fund significantly cuts down on the expenses with no experts to pay, and as an added bonus, an index fund will generally outperform mutual funds over the long haul.

Disadvantages

The drawback to an index fund, however, is that it is designed to exactly match the the index it is based on, which means that they are not completely safe alternatives to hand selecting stocks. Anytime the market goes down, an index fund will almost certainly follow. Some investors believe it is best to leave mutual funds in place when they decline with the hope that they will recover over the following years, while others decide to pull the money out of the fund and use a different investment strategy.

Also, since an index fund matches the market instead of trying to beat it, enormous gains are less likely. On the other hand, the fund typically offers steady growth over the long haul with less risk.

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