How does index funds work?
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Traditionally, when you invest in a fund, there are some people who manage it and decide what to invest in. These people are expensive, and take a portion of any investment income you earn from the fund.
In the 70’s, Vanguard (an investment company) got the idea to just follow a really simple algorithm for deciding investments like, “buy a bit of every company on the S&P 500.” This is obviously a way cheaper fund to run and costs way less in fees for the investor. Since they typically track different stock market indices, these types of funds have been termed index funds.
Even better, index funds often outperform the actively managed ones. You often get better returns and lower fees.
You and your 10 buddies each have 1000 bucks, alone you don’t have enough to buy all the stocks in the index you want to replicate in the right quantities. But if you put all your money in one basket you now together have 10000 bucks that is enough to replicate the index. In return you get each 1/10th share of the fund.
A **share** is a piece of a **stock*
A **fund** is a group/bundle of stocks for you to buy in one-go. Well, you don’t own each stock, but the fund represents the prices of those stocks, so if those actual stocks go up, then the fund goes up.
An **index** is a tracking of multiple stock prices. The Dow Jones and S&P 500 are most well known.
An **index fund** is a fund that “tracks an index. So if the S&P 500 (an index of 500 huge companies, weighted by market cap, so Apple is #1) goes up 12.6%, then any and all index funds tracking the S&P 500 should theoretically all go up 12.6% as well.
Investing in index funds is an easy way to **diversify**. If you only buy Apple stock, then if Apple tanks your investment tanks. If you buy 50% Apple and 50% Google and Apple tanks but Google goes up, they can balance out. Now do this with tens or hundreds of stocks. Diversifying lowers risk, but it also lowers reward (as you could invest only in Apple and pray it only goes up, and it be by a much higher % then say the S&P 500 does as a whole).
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