investing

Everything you need to know about investing like a pro with index funds

Friends walking together in the city | Sam Edwards/Getty Images

Lucky you, if you're in an index fund. The best-known market benchmarks -- the Dow Jones industrial average and the S&P 500 -- have been rolling to new all-time highs, taking index fund investors along for the ride.

Investing is a straightforward process once you understand that index funds are the best building blocks for your portfolio.

Here's the gist: Index funds are simply mutual funds or exchange-traded funds that track an index, such as the S&P 500. They are designed to give investors exposure to a broad swath of the stock market at a very low cost.

Know this: Index funds are distinct from actively managed funds. An active fund and an index fund may hold some of the same companies. But the active fund will hold them in different weightings and concentrations in an attempt to beat the index, leading to a vastly different set of risks and returns.

Index funds consistently outperform most active funds, and they do it with lower fees.

OK, what's an index?

An index is a set of companies that represents some segment of the stock market or even the entire stock market. The Standard & Poor's 500 -- S&P 500 for short -- tracks 500 large companies that serves as the nemesis for active managers who try to beat it. Funds that mimic the S&P 500 contain $2.2 trillion of assets. That means a lot of people own it.

The Wilshire 5000 is broader, designed to measure the performance of all stocks actively traded in the U.S. And then there's the Russell 2000, which measures the ups and downs of small-cap companies.

There are indexes for every sector of the market throughout the world -- hundreds of them.

"A good way to think about it is like a funnel. You could think about it in terms of the broadest of the broad markets and then imagine it narrowing to focus on specific types of companies," says Jim Rowley, senior investment analyst in the investment strategy group at Vanguard.

Investors can choose a single fund that tracks the world stock market or build their own template with index funds of individual countries or regions.

There are other ways to slice the pie that is the stock market. There are indexes that track companies according to size -- large, medium or small -- and indexes that follow one particular sector or industry, such as health care or technology.

There are many more ways to subdivide the stock market, but don't worry about them just yet.

Here's another wrinkle: Bond indexes split up the bond market in similar ways. Rather than segmenting bonds by the size of the company, they are grouped according to the creditworthiness of the company, because bonds are a debt instrument. They're also categorized by the bonds' maturity. For instance, short-term bonds are in one basket, while long-term bonds are in another.

Wait, that sounds complicated

The myriad options are overwhelming, but don't give up yet.

"One of the great things about index funds is that they are a great starting point," Vanguard's Rowley says. Vanguard was founded by John Bogle, the inventor of the index fund.

"If you want to build a broadly diversified low-cost portfolio, a smart way is to choose a U.S. market index fund, an international market fund and investment-grade bonds," he says.

Consider this example: Vanguard's Total Stock Market Index Fund includes 3,660 stocks. Its Total International Stock Index Fund is made up of companies in emerging markets and developed countries, excluding the U.S. It consists of 6,045 stocks.

Two funds, nearly 10,000 stocks, plus one high-quality bond fund. And just like that, you're investing like a pro.

advertisement

Show Bankrate's community sharing policy
          Connect with us
advertisement
advertisement

CDs and Investment

Can heirs cash an old trust?

Dear Dr. Don, The youngest of 6 children, I am 48 years old. My father joined the Navy at 22. In Italy, he met his bride and my mother, and returned to the U.S. to raise our family. In 1959, he bought a trust certificate... Read more

advertisement

Blog

Stephen Pounds

Are you dancing in the market with Tina?

Investors triple-teamed the market, boosting the Dow Jones Industrial Average (18,613.52), the benchmark S&P 500 (2,185.79) and the Nasdaq (5,228.40) to new records at the close Thursday  ... Read more


Connect with us