The Case for Index Funds

The plain answer

An index fund is an investment fund designed to track a market index. A market index is a defined group of investments used to represent part of a market.

The case for index funds is simple: they can give you broad diversification at low cost without requiring you to identify future winners. They aim to capture the return of the market they track, minus fees and tracking differences.

How it actually works

An index follows stated rules for selecting and weighting investments. An index fund holds investments to approximate that index. Some indexes cover a broad market, while others focus on a particular industry, company size, country, or asset class.

Because the fund follows rules instead of paying a manager to repeatedly choose investments, its operating costs can be lower. Costs matter because every fee reduces the return you keep, and that difference can compound over time.

Index funds also reduce the need to predict which individual investments or managers will outperform. They do not eliminate market risk. If the tracked market falls, the fund will generally fall too.

What this means for you

Look beyond the words index fund and identify what index the fund follows. A broad index may support diversification, while a narrow index may leave you concentrated in one part of the market.

Consider how the fund fits your overall mix, its ongoing cost, and how closely it follows its stated index. A low-cost index fund can be a useful building block, but your results still depend on the assets you choose, the risks you take, and how long you stay invested.

Common mistakes

• Assuming every index fund is broadly diversified.
• Choosing an index because its recent return was high.
• Ignoring costs because the percentage appears small.
• Holding several index funds with substantially overlapping investments.
• Treating an index fund as protection from market losses.

Related pages

• Investing overview
• The order of operations for your money