What are index funds and what’s the difference between them and regular stock trading?



What are index funds and what’s the difference between them and regular stock trading?

In: Economics

Index funds is like buying a box of crayons. When you buy the box you get all of them, even the colors you’re not as crazy about. Stocks are just individual crayons. There are different styles/themes of boxes of crayons just like there are different types of index funds (global, S&P500, Bond Index, total US stock market index)//(colors: tropical, skin tones, classic, pastels, etc).

Regular stock trading is buying specific stocks (Boeing, Ford, Amazon, etc.). If those companies do well, you do well. If they crash and burn, you don’t.

An index fund buys shares in the same proportion as they are in major stock indexes, like the Dow Jones Industrial Average (“the Dow”) or the S&P500, so the value of the fund tracks the value of the index. Since these are large and cover many companies, you’re not entirely exposed to the success or failure of any one company. And since the stocks in the fund are simple math, their overhead expenses are very low (there’s no active fund management team to pay). As a result, they’re less risky than most individual stocks and well diversified without thinking very hard or paying a fund manager.

An index is a collection of companies. That connection can be along several different lines, such as companies in the same sector, companies of similar size, companies in the same geographical area, or by adjacent sectors (think Tesla and Cobalt mines, but hundreds of times, another example is traditional car companies and oil companies)

An index fund is where people pool their funds to buy stocks from each of the companies on the index. Modern index funds use computers to highly automate the process to follow the index as companies come and go. You can buy a share in the fund and have a amall ownership in the pool.

They are highly popular as it self insulates against individual companies. In the example of Tesla and Cobalt miners, if Tesla finds a way to not need Cobalt anymore, then the Cobalt mine companies might lower in price while the Tesla stock would increase by more than enough to make up for it.

Index funds are mutual funds that contain all the stocks in a stock index like the S&P 500 or the Dow. The advantage of index funds is they track the indices more or less exactly (so knowing how your portfolio is doing is as easy as checking the relevant index), and that they’re essentially unmanaged.

Managing funds is expensive because financial managers are well-compensated, so this cost gets transferred to investors in what’s called the management expense ratio (MER). The MER is really just an annual commission you have to pay as a percent of your holdings *whether they go up or down*.

Typical managed funds will have MERs of 1.5% to 2.5% compared to index funds which charge in the 0.1% to 0.4% range.

Why do people pay high MERs? They do so because they might believe that they can cleverly choose funds that might beat the indices, or because they believe financial managers can make them more money by cleverly picking stocks.

Truth is though that when you take into account the higher MERs, managed fund almost never outperform the indices over the long term. They might make fantastic gains from time to time, but fantastic losses are also possible.

[A Random Walk Down Wall Street](https://www.google.com/search?client=firefox-b-d&q=random+walk+down+wall+street+pdf) is an excellent, inspirational book for newbie investors, and really lays out a very strong argument for choosing low MER index funds over high MER managed funds.