What Is An Index Fund?

You’ve likely heard of index funds. Perhaps you’ve seen a definition online that reads something like this:

“An index fund is a type of mutual fund or exchange-traded fund (ETF) with a portfolio constructed to match or track the components of a financial market index, such as the Standard & Poor’s 500 Index (S&P 500).”

If that looks Greek, you aren’t alone.

The stock market comprises thousands of individual stocks. They include businesses like Coca Cola, Apple, Netflix, General Electric, Wells Fargo and a whole sea of others. If we want to invest, we can choose to buy a handful of individual stocks through a brokerage account. But that can be risky. After all, if we choose to buy shares in a business that goes bust, we could lose money that we never see again.

If we buy an index fund, however, that allows us to diversify. It allows us to buy hundreds (sometimes thousands) of stocks with a single purchase. For example, when people want to measure how the stock market is performing, they often look to the S&P 500. The S&P 500 is known as an index. It represents 500 large US company stocks from a variety of different sectors. It includes retail sector companies like Wal-Mart; drug companies like Pfizer; restaurant companies like McDonald’s; technology companies like Apple and 496 other businesses from a variety of different sectors.

When we buy a S&P 500 index fund, we become a part-owner in 500 different stocks. Some of these stocks will perform well. Others won’t. Sometimes, almost all of them rise together. Other times, such as during a market crash, they almost all drop. But over time, if you’re patient, a S&P 500 index fund can reap strong rewards. For example, anyone who invested $10,000 in Vanguard’s S&P 500 index when it was first launched in 1976 would have seen it grow to about $1.4 million by February 10, 2022.

When someone talks about, “Beating the market,” they typically refer to beating the return of the S&P 500. But over an investment lifetime, this is an extremely difficult thing to do.

You’ve likely heard of some other indexes, too. The Dow Jones Industrials is an index. It represents 30 of America’s largest stocks.  You could buy an index fund (or a product called an ETF) that includes just these thirty stocks. However, all of the stocks that are part of the Dow are also part of the S&P 500.

The most diversified US stock market index is the Wilshire 5000. Despite its name, it includes about 3,700 American stocks (and not 5000). Every Dow Jones Industrials stock and every S&P 500 stock are also inside this index. You could own a sliver of all these stocks if you bought, for example, Vanguard’s Total Stock Market Index, or Fidelity’s Total Market Index Fund.

But before you ask, “Which index is best?” you should know that over long periods of time (20 years +) the S&P 500, the Dow Jones Industrials and the Wilshire 5000 earn similar returns. If you must choose one of them, select the one that offers the greatest diversification.

Diversification allows us to put our eggs in multiple baskets. So why stop with US stocks? After all, there were four ten-year periods when US stocks didn’t make money: 1929-1939; 1930-1940; 1999-2009 and 2000-2010. If we diversify our money to include international stock market indexes and bond market indexes, we increase our odds of making money over any ten-year period..

One of the easiest ways to invest in a total US stock index, total international developed world stock index and a total emerging market stock index (as well as a bond market index for added stability) is with a single fund that includes all of these indexes.

Such a fund allows you to attain global market exposure at the lowest possible cost. In this article, I offer several examples. If you buy one, you will beat the performance of almost everyone you know. You won’t beat them every year. But over a lifetime, that’s a near-certainty.

Andrew Hallam is a Digital Nomad. He’s the author of the bestseller Millionaire Teacher and Millionaire Expat: How To Build Wealth Living Overseas

This article and or podcast contains the opinions of the author but not necessarily the opinions of AssetBuilder Inc. The opinion of the author is subject to change without notice. All materials presented are compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. This article is distributed for educational purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, product, or service.

Performance data shown represents past performance. Past performance is no guarantee of future results and current performance may be higher or lower than the performance shown.

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