It's simple to become bewildered while beginning to invest with all the options. Stocks, bonds, ETFs, mutual funds — the list continues indefinitely. But one investment repeatedly has the trust of veteran and novice investors reposed in it: index funds.
If you ever found yourself wondering, what are index funds in investment, don't fret, you are not alone in your curiosity. And if you find yourself asking, “why do savvy, long-term investors love them so much?”, this article will give you everything you need to know — from the S&P 500 index fund basics to the benefits of low-cost index funds, and how they drive passive investing with index funds to create wealth in small pieces of time.
An index fund, literally, is a mutual fund or exchange-traded fund (ETF) that mirrors the performance of a specific market index. A market index, for our purposes of explanation, is analogous to a sampling of companies all jumbled together — such as the S&P 500 index, which tracks 500 of the largest publicly traded companies in America.
So what are index funds when it comes to investing? They are investment vehicles that automatically purchase the exact same stocks that are part of a particular index. That is, when you invest in an S&P 500 index fund, you're basically investing in a sliver of companies like Apple, Amazon, Microsoft, and hundreds more — all at once.
Since index funds do not try to "beat the market" but simply mimic it, they are a passive investing strategy — a strategy known as passive investing with index funds.
S&P 500 index fund basics are a great starting point in learning about index funds. The S&P 500 index consists of companies in numerous industries — tech, health care, finance, energy, and more — and therefore is a good gauge of U.S. economic trends.
Main Features of S&P 500 Index Funds:
Diversification: With 500 firms, your risk is diversified. If one of them performs poorly, others can make up for it.
Market-weighted: Large firms' performance weights more towards the index. So Apple, for example, has greater value than a small company in the index.
Low turnover: The index does not shift much, so fewer buying and selling transactions — another vital building block that brings less cost.
When people talk about what are index funds in investment, the S&P 500 tends to be the most commonly cited example. And for good reason — historically, it has averaged annual returns of around 10% before accounting for inflation over the long term.
Smart investors have one of the greatest reasons to love index funds due to the low-cost index fund benefits. Why it's important:
Old-school actively managed mutual funds cost more because managers are continually investing and trading in attempts to outperform the market. Those charges, referred to as expense ratios, generally fall between 0.5% and 2% per year.
Low-cost index funds, on the other hand, have expense ratios of 0.03%. That's because, with more of your investment staying behind and accruing interest over the long term.
Because index funds don't change stocks as frequently, they create less capital gains, thereby being tax-efficient relative to actively managed funds. It's another reason why passive investing through index funds is so appealing.
You don't need to wait to invest in the next Tesla or hold out for a market downturn to "buy the dip." Index funds cut out the guesswork of investing. The built-in diversification and constant exposure to the market make them a suitable choice for nearly every stage of your investing life.
It sounds counterintuitive, but time and time again, research has determined that low-cost index funds outperform actively managed funds in the long term — especially once fees are included.
The phrase passive investing using index funds is one technique that prefers buy-and-hold to attempting to time the market. It is most preferred by long-term investors who would rather have steady growth rather than short-term speculation.
Here’s why it is recommended:
Market Efficiency: Stock prices usually already incorporate all the information available. It's difficult to beat the market, even for professionals.
Emotional Discipline: Passive investing stops emotional buying and selling that result in loss.
Automatic Diversification: You can gain exposure to hundreds or thousands of stocks with one index fund.
The majority of the world's greatest investors, such as Warren Buffett, prefer passive investing. Buffett even recommended that the average investor would be best served by investing in a low-cost S&P 500 index fund and forgetting about it.
One of the most compelling features of index funds is how index funds grow wealth in the long term. They won't be as thrilling as high-risk, high-reward investments, but they are extremely effective long-term growers.
If you put $10,000 into an S&P 500 index fund in 1990 and did nothing, in 2023 your original stake would be in excess of $190,000 with a 10% average annual return. That is the magic of compound interest and passive investing.
Here’s a glimpse of it:
Reinvestment of Dividend Payments: Automatic reinvestment of dividend payments is available with most index funds, and this ensures that you receive maximum returns.
Compounding Returns: Profits beget profits over time — and time is your greatest friend.
Consistent Contributions: Ongoing investments (or dollar-cost averaging) smooth out volatility and dilute the effect of market fluctuations.
For those curious about how index funds build wealth, it's all about patience, consistency, and time.
Now that we’ve covered what are index funds in investing, their benefits, and how they grow wealth, let’s explore whether they’re the right choice for you.
Index Funds May Be Ideal If You:
That's why millions of Americans hold index funds in their 401(k)s, IRAs, and brokerage accounts.
If you're ready to get started with index funds, here are a few of the most popular and widely available ones:
They are similar to an S&P 500 index fund and deliver on the promise of cheap index funds.
So, what are index funds in investing, and why do savvy investors love them? Because they’re simple, low-cost, and effective, they allow anyone — whether a novice or a seasoned pro — to access the power of the market without complexity or high fees. Whether you’re investing for retirement, a house, your kids' education, or just to build long-term wealth, passive investing with index funds is one of the smartest strategies available.
With the benefit of low-cost index funds, exposure to the top-performing firms with S&P 500 index fund fundamentals, and the proven process of how index funds create wealth, it's no wonder they're the basis for intelligent portfolios. Take a long-term perspective. Invest consistently. Stick to the plan. And let the market — and time — do the hard work.
This content was created by AI