If you follow enough personal finance blogs or listen to personal finance podcasts, chances are you have heard the term “index funds” tossed around quite a bit. Odds are you also hear about how great of an investment they are. But what is an index fund? Today we will discuss what they are so you can have a better grasp on whether or not they make sense for your portfolio.
What Is An Index Fund?
First, let’s break down what an index is. An index is a tracking method that measures a specific item. For example, some indexes track the cost of gold, oil, agriculture, etc. You name it, and there is probably an index out there that tracks it.
Now, let’s dive into what an index fund is. Think of an index fund like a bucket. In that bucket, you are tracking one specific index. So to track it, you compile the top dogs that make up that index. So if you are tracking the large corporations in America, you would want to track the Amazons, Googles, and Apples out there. That is just a rough example but bear with me.
Now, as the personal finance expert that you are, you know that one of the best ways to measure a company success is to look at its financials. Check out the balance sheet, stock volume, and historical prices, income statements, etc.
Well, an index fund is basically doing this for you. An index fund has compiled the top businesses in the specific index you choose and buys stock in that company in hopes to profit. The company you are buying from (Fidelity, Vanguard, Charles Schwab, etc.) does the research to know which companies they should buy to fit into that index and exactly how many stocks from each company.
And so you, the buyer of the fund, gets to profit on the growth of that index as a whole (or loss on any declines). Index funds are a great investment since they are inherently diversified (you own multiple companies in one swift purchase) and you also most likely are exposed to international markets as well (most top businesses have business in other countries as well as workers). So really it is the best of both worlds.
It is also important to know that you could virtually create your own index fund if you wanted, just by diversifying into the top businesses in a specific index. However, an index fund does all of that work for you (woohoo time saver!).
Index funds are a great portfolio starter and historical data shows that they outperform normal stock picking in the long-term as well. The one downside to index funds is that most institutions that you buy from (Fidelity, Vanguard, Charles Schwab, etc.) require you to contribute a certain amount, usually a couple grand.
ETFs
The good news is that if you don’t have that much money but still want to start investing, you don’t have to feel like you’re missing out. Instead, you can buy an ETF of the index you were interested in.
An ETF is basically an individual stock of an index fund. So instead of having to pay a certain amount to buy into the fund, you only pay the ETF price that trading day. Another benefit of ETFs is that you can watch the price fluctuate through the day and try to buy low. Of course, the downside of this is the temptation to constantly day trade, which could result in some serious losses as well as taxes owed.
Final Thoughts
Overall, index funds are a great investment. This isn’t the first time you’ll hear that or the last. Now that you read this article, you should be able to understand what index funds really are and so you can add them to your portfolio. Let me know what your favorite index is in the comments!
Gina DiMasi
Gina DiMasi is an organizational finance whiz. Gina is an avid investor, educator and aficionado of bitcoin and other modern investments. In addition to being an all around nice person, Gina has a degree in personal finance studies from Framingham State University. When she's not running numbers or blogging up a storm, Gina actively volunteers with Habitat for Humanity.
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