What an index fund is
An index is a list of companies, such as the S&P 500 (about 500 of the largest US companies) or a total stock market index (almost every listed US company). An index fund (or an index ETF, which trades like a stock) simply buys them all, in proportion to their size. Nobody picks winners, so it’s cheap to run.
| Common index | What it holds |
|---|---|
| S&P 500 | About 500 large US companies |
| Total US market | Almost every listed US company, large and small |
| Total world | Thousands of companies around the world |
| US aggregate bond | US government and investment-grade company bonds |
Why it usually wins
- You get the market’s return. Some companies soar and some fail, but you own all of them.
- It’s spread out. One company going bust barely moves an index fund.
- It’s cheap. Broad US index funds often charge under 0.1% a year (the expense ratio). Actively managed funds often charge 0.5% to 1% or more.
- Most stock pickers fall behind. S&P’s SPIVA reports, which track US funds against their benchmarks, find that most actively managed funds do worse than their index over 10 to 15 years.
- It’s tax-efficient. Index funds and ETFs trade less, so they pay out fewer taxable gains each year in a regular brokerage account.
What fees cost you
$10,000 invested for 30 years, growing 7% a year before fees:
| Yearly fee | After 30 years |
|---|---|
| 0.1% | $74,017 |
| 1% | $57,435 |
| Difference | $16,582 |
The fee comes out every year, and so do the returns it would have earned. The compound interest calculator shows growth with your own figures.
Over 30 years, a 1% fee costs you
$16,582
- You keep (1% fee)$57,435
- Lost to the higher fee$16,582
Assumes a 7% return every year before fees. Real returns vary, but fees come out every year.
Picking your own stocks
It can be fun, and some people do well, but:
- A few stocks are risky: one bad result can wipe out years of gains.
- Trading costs and tax add up if you buy and sell often.
- It’s hard to tell skill from luck over a few years.
If you want to try, keep it to a small share of your money, and the rest in index funds.
How to start
Most people can buy a total market or S&P 500 index fund inside their 401(k) or IRA, many with fees under 0.1% a year. Check your 401(k)’s fund list for the expense ratio of each fund: the index funds are usually the cheapest. Outside those accounts, most brokerages sell index funds and ETFs with no minimum and no trading fee.
A target-date fund is an easy one-fund choice in a 401(k), but compare its fee: some charge several times what a plain index fund does.
Invest money you won’t need for at least 5 years, and keep going when markets fall: selling in a panic turns a temporary fall into a real loss. Start with investing basics if you’re new.