Index funds are a type of “mutual fund”. A mutual fund is a bunch of money (a fund) owned by a bunch of people (mutual). Back in the day, all mutual funds were “actively managed”. That means a smart manager was paid to take all that money, and buy a bunch of stocks with it at their discretion. People who wanted to invest would put some money into the mutual fund and they would get a piece of all the stocks the smart manager decided to buy. It was a nice way to diversify your portfolio without having to do all the research and trading yourself.
But here’s the problem. The smart managers charge a high fee for their service. And they’re competing against a bunch of other smart managers who also charge high fees. So all the individual investors are paying a lot of money to trade stocks back and forth and end up with less money than those stocks actually provide without the added fees.
Enter the index fund! Instead of paying a smart manager a high fee, an index fund is a type of mutual fund that just buys EVERY stock in a list. For example, an S&P 500 index fund owns the 500 biggest stocks in the US. It turns out that the market is very “efficient”, so the stocks are priced about right. That means buying all of them (even the “bad” ones) is a great way to fully diversify and guarantee your fair share of the market growth. Index fund fees are typically 10x-50x lower than actively managed mutual funds, and their performance is almost always better.
Note that my favorite way to invest is in a target date index fund. I dive into mutual funds, index funds, ETFs and target date index funds in a much more comprehensive way in my “How to Invest in Index Funds” course is on sale all week long!
As always, reminding you to build wealth by following the two PFC rules: 1.) Live below your means and 2.) Invest early and often.
– Jeremy
