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