index funds & indexes
Index funds allow average people to participate intelligently in the stock market, by offering diversification and low fees.
The "why" of index investing is widely available.
(In a nutshell, actively managed mutual funds do only about as well as index funds but charge higher fees; and individual stock investors can do even worse, mainly because they keep stumbling over bum advice - which is also widely available.)
So this article covers the basics on the "what" of index investing:
exactly what indexes and index funds are, how they select and weight stocks, and how different index families divide up the market.
That's followed with some simple suggestions on building portfolios with index funds and ETFs.
Index Basics
A stock index is a hypothetical portfolio of stocks - a list of names and numbers of shares - selected according to some established criteria.
An index fund is a real mutual fund that buys stocks and holds them in a portfolio that approximates the index.
The most widely followed index is the S&P 500, consisting of 500 hand picked large companies
selected by Standard & Poor's.
The best known index fund is the Vanguard 500 Index Fund from The Vanguard Group, which tracks the S&P 500.
Most modern indexes weight stocks according to their market capitalization.
That means that if A and B are two companies in the S&P 500 and the market capitalization of A is twice that of B, then if you invest in an S&P 500 index fund your proportional ownership of A will be twice that of B, dollar-wise.
That's the same as saying that you'll be allocating your money in the same proportions as the whole market is.
That's a good thing if you believe in market efficiency, because you'll be passively benefiting from whatever logic the market used to make its allocation decisions.
If you don't particularly believe in market efficiency, that's still okay - the index is still a diversified bunch of stocks.
(The Dow Jones Industrial Average doesn't weight its companies this way, because it's a throwback to olden times.
It really is just "a bunch of stocks", where the weighting of each stock within the index has no particular significance.)
The performance of an index fund
won't exactly match that of the index, for at least two reasons.
First, the fund needs to charge a management fee to cover the expenses of running a "real" mutual fund, including salaries of brokers and admin people who keep the customers' accounts straight.
Second, the fund has some flexibility in exactly how closely they track the index.
(That can actually be a good thing: some well-known funds consistently show some skill and frequently manage to
beat their index, even after fees.)
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