Index funds are mutual fund portfolios which group a range of stocks or other markets. A total stock index fund would consist of every stock on the exchange, like the New York Stock Exchange (NYSE). The goal is to benchmark the stock group it’s indexing. The price would rise or fall depending on what the stock market would do on a given day. An S&P fund has the 500 stocks in the Standard and Poor’s stock market indices and would rise or fall with the S&P movement. Buying stocks this way covers a variety of industries and companies. This investment strategy doesn’t count on picking a single stock or two that will rise in value, but the indexed value rises or falls at the same rate as the benchmark it’s indexed to. This group of stock investors miss the small stocks that make millionaires, but these investments generally miss the fad stocks people jump into that later tank.

How To Invest In Index Funds

Investment companies have formed several versions of the stock index fund. The S&P 500 stocks are popular and well known and was the first index funds. The total market funds buy all the stocks listed on a particular market such as NASDAQ, NYSE, Dow Jones Industrial Average (DJIA) and other domestic markets.

New York Stock Exchange
Credit: Public Domain courtsey Franz Golhen.

Investors can find these investments focused on where they want to put their money. There are groups focused on industries such manufacturing, banking and many other stock issuing businesses. The index investor can buy funds in whatever area he likes.

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This type of investment can be broken down into large, medium, and small capitalization (caps). Caps refer to the size of the company, and the index fund may have a group of each size, or a mixture of different caps.

In addition to buying domestic stocks this way,  the same method of purchasing stocks can be done with international stocks. These investments can benchmark to various international stock markets.

Asset allocation is a managed portfolio that owns different index funds. The plan is to diversify the investment and keep the highest earning funds in the portfolio.

Exchange traded funds (ETF’s) are securities that track an index, commodity, or group of assets. An ETF is traded like a stock and responds to daily price fluctuations like a stock. This allows them to be sold short, bought on margins and to purchase one share.

Bond index funds are grouped by the bond issuer, credit rating, and maturity. Groupings also allow one to track an index. Bonds are generally considered a safer investment than stocks, but with less chance to rise in value dramatically like a stock. They are subject to the interest market so if interest rates rise, bonds with lowers rates aren’t as good an investment. If interest rates fall, the investment becomes better.

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Investment companies offer commodities under this grouping for sale. Commodities are materials and processes used for manufacturing. Copper, tin, gold, oil, silver and energy are a few examples. Commodity indexes may have a broad range of elements or weighted to a specific group such as energy or minerals.

Most investment companies offer versions or a variation of these funds. Any investment requires a certain amount of research, and investing in index funds is no different.

Index Funds Advantages

These investments are different from mutual funds in that they are passive investments. These investments aren’t actively managed or analyzed like mutual fund stocks. Some  focus on low tax rates to reduce the load. Index funds tend to perform better than 85 percent of mutual funds. Most mutual fund portfolios don’t do better than the S&P 500. All an index fund has to do is match the benchmark market performance it’s matched with. If the benchmark grows, the investment grows. If it declines, the investment declines. The expectation for returns is based on the hope that, over time, the benchmark value will increase. This is a good long term strategy.

Because index funds aren’t constantly looked over by a highly paid manager and analyst, the overhead, or load, is low. This is a big advantage index investments have over mutual funds or single stocks. Mutual funds have managers that constantly monitor the stocks in the portfolio to try to pick a stock on the upswing. This increases turnover. They buy and sell stocks regularly, which increases load to the mutual fund. These loads drain and can eat up any profit or gain from the investment. ETA’s can also fall into this category.

In a television interview, Warren Buffet recommended index funds over mutual funds for investors because of the low overhead. He said they are good for people who don't spend the amount of time it takes to research a stock.

Disadvantages of Index Funds

Some investors see this type of investment as holding your own and not being profitable enough. Index funds hold even with their benchmark and don’t beat anything, although some occasionally have done better than their benchmark. While an overachieving stock can increase the funds value, an underachieving one can drag it down. The hope is that they will even out and match the benchmark, which they normally do.  An investor makes money on the belief that the stock market, or whatever index they’ve alligned their money with, will increase in value over time. This type of investment generally does pretty well in tracking their benchmark and don’t underachieve.

There is an index fund for everyone. There are index investments with a social conscience, varying diversity of stocks, high or low yield, company size, company product and domestic or international investments. They offer a wide exposure to the market at a low cost. In a television interview Warren Buffet recommended this investment as best for most people because of the low load, and not having to spend an inordinate amount of time doing research.

Two things are important to remember when investing in anything. Opinions by different financial experts often clash. It’s not hard to find an investment expert that disagrees with another investment expert. Investment companies post a statement on their website that says, in effect; No Guarantees.