In a time of inflation and economic uncertainty, stocks can seem like an appealing place to put your money because of their potential to gain value more rapidly than some other investments. But let’s face it: Most people lack the training, experience, and time to successfully research and predict whether individual stocks will rise or fall over time.
That’s one reason why many investors turn to mutual funds that hold a basket of stocks and other securities. Often, professionals who handle the research manage mutual fund portfolios. And they are diversified across many investments, so they’re designed to carry less risk of a significant loss than putting your money in a single stock.
Index funds are one type of mutual fund. They’re called that because they seek to track the performance of a market index.
Index funds tend to be very diversified with the goal of lessening risk, particularly in the long term. They’re easy to understand and simple to track, so they appeal to many beginning investors. And often, they carry lower fees than other investments.
But index funds may not be the best choice if you’re looking for a short-term investment. When the overall market takes a nosedive, chances are your index fund will, too.
Here’s a guide.
What are index funds?
An index fund is a mutual fund that attempts to mirror the performance of a market index, like the Standard & Poor’s 500 and the Russell 2000—or sometimes a smaller, more specialized index, like the CRSP U.S. Large Cap Index. Those indexes list many companies and combine the market performance of all the listed companies into one measurement.
You don’t invest in the index itself. Instead, an index fund either holds shares of all the companies listed in the index or a specialized subset of listed companies.
Over the long term, broad-based stock indexes have performed well. The S&P 500 has seen significant drops from time to time, but since its current format was adopted in 1957, the index has gained an average of 10.7% a year. Index returns over the last 10 years have been even better.
What do index funds cost?
Index funds typically are maintained in a “passive” way, simply mimicking an index without a manager frequently buying and selling stocks. That’s why they often (but not always) have lower fees and other expenses than more intensively managed funds. But be sure to check on costs before you invest. Some funds tracking the same index cost more than others.
Photo: Daniil Peshkov via 123RF
How do index funds perform vs. other funds?
Star stock pickers usually manage certain mutual funds that soar in a given year. But many experts would argue that index funds generally outperform most actively managed funds. And higher fees may impact the net returns of even the best non-index funds.
How about downsides?
Investing in the stock market always carries a measure of risk, whether it’s individual stocks or a fund with a basket of stocks.
While index funds aim to shield you from some of the risks of individual stocks going down, there are times when an entire index declines. In the 20-year period ending in 2021, the S&P 500 sustained drops of 10% or more in 10 of those years, although the index eventually posted full-year gains in all but three of those years.
So, as is often the case with stocks, it’s best to see index funds as a long-term investment held over several years, giving the market time to climb back from downturns. If you expect you’ll need to cash out soon, perhaps because you’re retiring or buying a house, you may want to pass on index funds.
What to know before you invest
Look at the fund’s prospectus and its latest shareholder report (usually available on the fund provider’s website) to determine which stocks are in the portfolio. Also, ask what fees are involved. Check the index performance tracked by the fund over the last few years. And check the fund’s rating by a service like Morningstar.