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What is an Index Fund?

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First there were stocks. You could own individual pieces of a company. Canada Best Lemonade Stands, Inc. sells part of itself to raise money to build more lemonade stands in the northern United States. You buy one and in return you get a piece of the profits relative to the percentage of CBLI you own.

This was great for the individual investor; you could make money from the burgeoning lemonade industry without starting your own business. You could take advantage of existing businesses and get a part of their profit.

This was also a lot of work. You had to do a lot of research to figure out which companies to buy, based on their strength and their markets and the potential for all of that business growth.

Then came mutual funds. A mutual fund is an investment vehicle where many investors pool their resources to give them larger leverage in the market. A bright fund manager would raise money from many small investors and spend all day researching good companies and buy their shares. Having one person or a team of researchers pick good stocks allows better investments (in theory). Having lots more money than any single investor could provide gives bigger opportunities (in theory). Yet bigger also means bigger headaches.

Mutual funds were great in some ways, but they had their flaws.

Index funds can be much better.

What is a Stock Market Index?

A stock market index is a measurement of the performance of several stocks together. Famous examples include the Dow Jones Industrial Average, S&P 500 index, or the NASDAQ index. Even though there are tens of thousands of individual companies in all sorts of industries, talking about the market in terms of indexes simplifies and clarifies. For example, the Dow is 30 enormous American companies; it reflects what's truly big business. The S&P 500 represents a larger swath of businesses. There could be an index of stocks with headquarters in a particular state or an index of stocks which make musical instruments. An index is just a way of looking at a cross-section of the market in an interesting way.

What is an Index Fund?

An index fund is an investment vehicle which offers the opportunity to own small pieces of every stock represented by the index. When you buy into it, you're buying a lot of pieces of shares of a lot of companies. An index fund is different from a mutual fund because it's not actively managed by a professional fund manager. A mutual fund has someone in charge who says "Canadian lemonade companies are going to lose money this year. Let's buy Mexican sugar cane factories instead." If that analysis is correct, the fund could make money. Unfortunately, it might not be correct, and it might be a terrible time to sell Canadian lemonade companies or a terrible time to buy Mexican sugar cane factories.

An index fund is a passive investment. It reflects the index—just a list of stocks. Sure, that list may change, but it won't change very often. Rather than someone making a lot of active trades, trying to stay ahead of the market, it's really boring.

Boring is good.

Other types of index funds exist. An index bond fund is an investment in company bonds, rather than company stocks. Think of them as buying shares of loans to governments and companies. Also boring, but in a different way.

Why are Boring Investments Good?

Successful companies can be boring. They may not make flashy trades. They probably don't make a lot of exciting, splashy deals. They just make and sell good products and services and get a few more customers every year and become a little more productive and earn money reliably for their owners.

With an index fund, your ability to earn money rests on the state of the economy. If companies are making money, your money will grow. There's little choice involved; you own shares in profitable companies.

Both mutual funds and index funds can lose money. Some years they will.

With a mutual fund, your ability to earn money rests on the accuracy of the choices made by the manager. If those choices are good, you could get good returns. If those choices are average, you'll get average returns, or worse. (On average, mutual funds underperform relative to the market.)

The Dirty Little Secret of Mutual and Index Funds

That's right; the dirty little secret of mutual funds is that most mutual funds make less money for their investors than index funds do. The index funds best feature is that they're boring. Because no human is continually buying and selling shares—because an index fund always matches the underlying index, which so rarely changes—you're not paying for change. You get the benefit of stability. The best index funds are benchmarks against which you can measure the performance of any other investment.

A mutual fund manager has to get returns better than the index fund to make up for all of the buying and selling that happens. Most mutual funds cannot do this reliably over the long term. Sure, some do—but how do you predict which ones will? That's like as predicting which individual stocks will do well. (Actually it's more difficult; value investing helps choose good stocks.)

When you buy into a mutual fund, you have to pay the mutual fund manager a percentage of your investment as commission. To earn the same returns as an index fund, the mutual fund manager has to outperform the market by that much more. (Index funds often have commissions, but they're dramatically smaller!)

With an index fund, count on the fact that successful companies will continue being successful over the long term. Sure, it's boring, but boring growth you can buy and forget will help you turn your investment now into long-term wealth.

Ready to learn how to invest in index funds? The answer is the same as how to invest in stocks: set up a brokerage account, find the right index fund, and buy it! Easy as 1, 2, 3.