Indexes are designed to reflect the performance of a specific segment of the stock market. For instance, the Dow Jones Industrial Average looks at the performance of the top companies in the US; whether Dow Jones goes up or down is indicative of how the stock market as a whole is doing.
Index funds are investment funds that seek to match an investment index, like the Standard & Poor 500, by buying proportionate amounts of stocks from each company listed in the index. When the S&P 500 goes up, index funds targeted to it also go up. Commensurately, when it goes down, the index funds that target it also go down.
This makes them very unlike mutual funds. Managed mutual funds under perform in the stock market a whopping 80% of the time, according to the Motley Fool. Why? Because most investment managers aren’t really great at predicting what the stock market is going to do; if they were that good, why wouldn’t they be living on a Tahitian island after investing their own money?
But index funds don’t depend on a person to actively manage them. They are low risk investments compared to many other types of stocks; if you buy into an index fund, you’re not going to make huge windfalls, but you’re also not going to lose your shirt. This makes them ideal as short-term or long-term investment tools when you can’t afford to lose your money.
Sure, you’re not likely to get wildly rich on index funds. But you have the nearest thing to a guarantee you can expect to earn a steady and fair return on your investment.
If you don’t want to invest in an index fund, you should at least compare the investments you have right now with index funds to gauge whether they’re outperforming the market or underperforming.
Examples of Index Funds
Dow Jones Industrial Average – the most widely-respected index in America
NASDAQ – An index that focuses on tech stocks and cutting-edge businesses.
Russell 2000 – An index that measures small-company stock performance. It’s both very diversified and somewhat volatile compared to the other indexes.
S&P 500 – another major general American stock index
Wilshire 5000 – Also called the Total Stock Market Index, the Wilshire 5000 tracks almost all publicly-traded US companies.
Nikkei 225 – a Japanese index roughly equivalent to the US S&P
FTSE 100 (or the Footsie) – British index equivalent to the Dow Jones Industrial Average