Understanding Index Funds

Wesley Watkis

There are so many facets to the financial market, but understanding index funds is key to understanding your investments. Index funds tend to have fewer fees and fewer administrative costs than actively managed mutual funds, which makes them a fairly sound investment overall. Knowing what they are and how they work will let you make the decision about how to invest your money and how to look for the fund most likely to get you a great return.

What are Index Funds?

Index funds and mutual funds have a lot in common. In both types of investments, the fund that you invest in represents a group of stocks picked for their high return value. You don't buy an individual stock, you buy a share of these stocks as a whole. Your investment sees returns based on how well the entire group does. Because of this, these funds tend to be lower risk than many individual stocks. While some of the stocks will lose value, many will probably also increase in value leading to a high probability of an overall gain.

The difference between an index fund and a mutual fund is in how it is managed. Mutual funds have managers actively selecting stocks to include in or remove from the fund. They fully research each stock to make sure that they are choosing the ones that are most likely to grow. Index funds also hope to have a great return, but they go about this in another way. Instead of being actively managed, they follow an index of the stock market. An index is a subsection of the stock market (such as the Standard and Poor's 500). By choosing a subset of the stock market that is performing well, the fund buys these stocks and hopes to see a return on the investment. Because an index fund uses this predetermined group of stocks instead of actively selected ones, the administrative costs are lower and this savings is passed down to you.

Risks of Index Funds

While the costs are lower, less oversight makes these funds a bit riskier. Since they follow a financial index, they can never outperform it. A mutual fund, on the other hand, can remove a stock from the fund that is underperforming in the interests of raising the profits. An index fund may take money out of underperforming stocks, but they tend to follow the market instead of trying to outguess it, and that can lead to lower returns. When trying to understand index funds, however, you should know that they tend to perform quite well overall when you account for the additional fees mutual funds charge.

Making the Choice between Mutual Funds and Index Funds

Understanding index funds is an important step when you are trying to decide what will give your money the best rate of return. Knowing the risks and the advantages of these funds, especially as compared to mutual funds, is critical. You want the best rate of return on your investments, so taking this into account along with your tolerance of risk will help you decide which option is best for you.

Questions? Email me at wesley@thewandwgroup.com and visit our website at http://www.thewandwgroup.com New Money Talk is a weekly article focusing on retirement, personal finance, and estate planning.
Comments and questions are welcome, but because of the volume of email, personal responses are not always possible.
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