What Is an Index Fund?

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Investing in stocks and bonds is a good way to earn an attractive return on your investment and retirement portfolios. However, analyzing the stock market to find individual stocks to invest in can take a lot of time.

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One way to invest that takes less study and analysis is to purchase stock market index funds. Here's how stock market index funds work, and why they might make a good fit for your investment strategy.

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Stock Market Index Fund Examples

Stock market index funds track the fluctuations in prices of a selected group of stocks or other financial assets, such as bonds.

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For instance, the most popular index is the Standard & Poor's 500 index, which is made up of stocks of the 500 largest publicly-traded U.S. companies.

Examples of different indexes are the: :

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Dow Jones Industrial Average (DJIA):​ Consists of 30 large-cap corporations

Nasdaq Composite Index:​ Contains more than 3,000 stocks listed on the Nasdaq exchange.

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Bloomberg U.S. Aggregate Bond Index:​ Represents the total bond market.

Russell 2000 Index:​ Includes 2,000 small-cap publicly traded companies.

Investing in Stock Market Index

Stock market index funds are a way for beginners to invest in stocks, diversify and minimize their risk by purchasing shares in all the companies in the index rather than investing in just one or a few individual stocks. The portfolio of an index fund is designed to mimic the performance of the index.

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An index fund has a portfolio made up of the components of a financial market index, which could be either stocks or bonds

Investing in individual stocks and bonds can be risky, but you can minimize your risks and earn a good return by investing in stock market index funds.

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Index funds are low-cost passive investments. The index fund managers do not actively buy and sell the stocks in the fund like actively managed mutual funds where the managers are constantly picking individual securities and trying to time the market to increase the return.

You can buy index funds that concentrate on various asset classes, such as small companies, large corporations, international companies, emerging markets or specific sectors, such as technology or energy. The S&P 500 is one of the most popular diversified stock funds that has shown a consistent average annual return.

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Vanguard and Fidelity are examples of investment brokers that offer a wide range of index funds and other investment products.

Mutual Funds Vs. ETF

Mutual funds charge management fees and expenses. Exchange-traded funds (ETF) have lower fees and a low expense ratio.

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ETFs are traded every day on the stock exchange. The price will fluctuate depending on the market and movement of the index. Mutual funds, on the other hand, are priced at the end of each day based on the net asset value of the fund.

Index Funds Advantages and Disadvantages

Advantages:

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  • Diversification:​ The funds are spread over a large number of stocks, which reduces the risk.
  • Lower costs:​ Because index funds are passively managed, they usually have low fees and expense ratios.
  • Passive investment:​ Since you're not picking individual stocks or bonds, you don't have to monitor market movements every day to make decisions on buying and selling.

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Disadvantages:

  • Not good for short-term gains:​ Index funds are typically slow to steady gainers, but you'll miss out on short-term gains from hot-performing stocks.
  • Tied to market trends:​ Index funds will follow the overall market trend, both upside and downward dips.
  • Not as diversified as advertised:​ Most index funds allocate their funds based on market capitalization, which means that your investment could be concentrated in a small group of large-cap companies rather than equally spread throughout all the companies in the index.

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