Investing 101: An introduction to index funds and passive investing

This is a guest post from ABCs of Investing, a new site for novice investors. ABCs of Investing offers two short and simple investing posts each week.

Personal finance bloggers are vocal proponents of passive investing in index funds and exchange-traded funds. But not everyone knows much about these, and not a lot of bloggers do a good job of explaining the basics of passive investing. This post is intended to explain the basics — along with the basics of the basics!

I was inspired to write this article because of two separate but identical conversations I recently had with friends. They went something like this:

Friend: What do you invest in?
Me: I do passive investing. You know — investing in index funds and ETFs. ETFs are kind of like index funds.
Friend: I see… [Blank stare.] Me: Do you know what an index fund is?
Friend: Nope.
Me: It's a fund that invests in all or most of the stocks of a stock market index and gets a return which is equal to the index return minus a small fee.
Friend: I see… [Blank stare.] Me: Do you know what a stock market index is?
Friend: Nope.
Me: I see….

With active investing, an investor tries to pick stocks that will outperform other stocks. With passive investing (also known as index investing or “investing in index funds”) an investor simply uses mutual funds to buy all of the stocks in the market. The basic idea is that with greater diversification and lower costs, a passive investor will generally do better than someone who buys actively-managed mutual funds.

Let's cover some of the basic facts that my friends need to learn in order to understand passive investing.

What is a Stock Market Index?

A stock market index (or just “index”) is a number that refers to the relative value of a group of stocks. As the stocks in this group change value, the index also changes value.

For example, an index might have a value of 1000 points at the beginning of the day. If the stocks in that index rise in value by 1% during the day then the index will be at 1010 points at the end of the day. Does this sounds familiar?

The Dow Jones Industrial Average (commonly just called “the Dow”) and the S&P 500 are two examples of stock market indexes. Most people (including my friends) who think they don't know what an index is, in fact probably have a reasonably good idea.

What are Index Funds?

An index fund is a mutual fund that invests in the same stocks that are contained in a stock index, in the same proportion as in the stock index.

Imagine a stock index — let's call it the ABC Index — that contains two stocks: IBM and Google. Let's say that the ABC Index is currently made up of 60% Google and 40% IBM. If an index fund is based on the ABC Index, then it too will also invest in Google and IBM — 60% of the index fund will be Google and 40% will be IBM.

These percentages will change as the values of Google and IBM change. If the price of Google stock increases and the price of IBM stock decreases then the index will change so that maybe 65% will be Google and only 35% will be IBM.

The two main arguments in favor of index funds (and passive investing) are:

  1. Most managed mutual funds can't beat their index over any length of time, and it is impossible to predict which ones will beat the index in any given time period.
  2. The significantly lower costs of index funds will ensure that, on average, index fund investors will have better returns than their managed mutual fund counterparts.

If you assume that the average mutual fund will earn the same return as the stock market index minus fees, then an index fund will outperform the average mutual fund because it has lower fees.

As an example, if a managed fund XYZ earns the same 8% return as the S&P 500 in 2009 but it charges a 1% fee, then the XYZ return will be 7%. If the ABC Index fund is based on the S&P 500 and only charges a 0.25% fee then the ABC Index fund return will be 7.75% which is three-quarters of a percent higher than the average managed mutual fund.

Over time, that difference is significant. After 25 years, the investor with the lower fees will have 19% more money invested than the investor paying the higher fees.

Passive Investing is Easy

If you want to get into passive investing, then I suggest doing some more reading on the topic, as well on possible asset allocations. Some books you might consider include:

Regardless of whether you believe that index funds are better than managed funds, it's certain that passive investing is much easier. You don't have to analyze mutual funds or stocks — just pick some basic index funds and away you go!

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Writer's Coin
Writer's Coin
11 years ago

They may not be as sexy as stockpicking, but there’s a reason why so many smart, informed people are fans of them. And while many argue that aiming to “match” the market is aiming too low, you can still mix and match your allocation to different indices to outperform the S&P 500, or whatever other benchmark you have.
I own all my index funds through Vanguard, the King of Index funds.

Miranda
Miranda
11 years ago

I love index funds. A substantial portion of my retirement account is in index funds. And, while I have a mix of other things, the index funds I have are the anchor.

Christy
Christy
11 years ago

Okay, I’m going to ask the true “dummy” question here … where the heck does one start looking to find/learn about/ invest in these magical index funds?

A primer on that would be most helpful to someone like me.

Jeff
Jeff
11 years ago

@Christy – those 3 books mentioned in the post are probably a good way to get started, and I personally recommend “The Bogleheads Guide to Investing”. It’s the first book on “finance” that I’ve ever read…and I actually enjoyed it! Still a heck of a lot I don’t know, but I think it’s a very good start.

simplesimon
simplesimon
11 years ago

I am going to second and emphasize what Writer’s Coin has said about matching the market. People choose managed funds because they want to do better than the average investor while people choose index funds because they want to accept what the market has given them. In a managed fund’s quest to beat the market, many of them do worse, and there is no way in knowing which ones will do better before the fact. With index funds, you know you’re going to do just as well as the markets (minus tiny fees). @Christy: I’m going to do a shameless… Read more »

Don
Don
11 years ago

The books listed are good references. Essentially, if you get low enough fees (under 0.5% of assets) you are pretty much going to be in an index fund. My favorite ETFs, which are like index funds that you trade through a brokerage account (beware frequent trading though or the brokerage costs will get you) are: VTI – Vanguard Total Stock Market VEU – Vanguard non-US Stock Market TIP – Ishares inflation-protected treasury Buy 33% of each for a Margaritaville portfolio. Rebalance once a year. I make my IRA contributions once a year, and buy appropriate numbers of shares to keep… Read more »

Scott NJ DAD
Scott NJ DAD
11 years ago

Index and managed funds both have pros and cons. What if you want to invest in companies that are developing alternative energy technologies. Is there an index for that?? Is it an area of investment where research and info matter more? But for run of the mill investing, the low expenses are hard to beat. Also, don’t ignore the ETF’s that act as index funds, sometimes they have even lower expenses than the open end funds. Christy go to Vanguard, and use their education tools. It is a good start. FYI – The #1 impact on ROI is expenses, the… Read more »

Doubters abound
Doubters abound
11 years ago

Be aware that there are many doubters out there. In particular, you will see a lot of numbers about how investing in equities is better than sliced bread, white bread, or any other kind of bread. However, times like these — when the market has declined substantially — are much better times to buy equities. If you are a sucker like me, and most of your investment was made at twice this price, you may not break even on your money for a decade (not an exaggeration — the last time the market was that high was in 2001, again… Read more »

Trevor
Trevor
11 years ago

Index Funds have been what I’ve been hearing more about lately. Better go check them out!

John
John
11 years ago

I’ll echo the plug for http://www.bogleheads.org/forum. There’s a lot of people there who can help you translate the theory to your real world scenario. You can post what your situation is in detail (I have a 401k with these funds, my wife has a 403b with these funds…) and they’ll divide it up in way that makes the most sense including tax efficiency.

joejoeice
joejoeice
11 years ago

I am also a big believer in ETFs and index funds. JD, a follow up article could be the differences between these two types of investments. For those who are buying in bigger amounts or holding for a long time, ETFs are most cost effective, since most of the costs are in the buying and selling commissions. In extreme cases, the advantage of one or the other is obvious but figuring the best option in borderline cases is complicated. Also, comment #5’s question about alternative energy funds makes a good point about how even index funds can result in poor… Read more »

SadieinDC
SadieinDC
11 years ago

Thanks for this post! I would love to see more posts like this, and especially posts on asset allocation. I’m good at saving, good about investing (as in, I’m good at “Investing 101”), but I would like to be better at asset allocation….I’ll check out the books you suggest.

Bill M
Bill M
11 years ago

I am all for index funds, they charge less and most of the time outperform managed shares. I believe that a well diversified portfolio of index funds will produce a good return in the long term.

Scordo.com
Scordo.com
11 years ago

I would also look into ETNs or “Exchange Traded Notes.” I wanted to purchase a broad commodities type index fund a couple of years ago (that tracks oil, gold, etc.) and I found the iPath Dow Jones-AIG Commodity Idx Fund(DJP). It’s dropped in value recently but I think it’s a nice option to look at in addition to Vanguard index funds (which are no brainers!).

http://www.scordo.com/blog/blog – a practical living blog

Stray Cat
Stray Cat
11 years ago

This is quite a good strategy for investing. Today all the indexes are low and it’s time to jump in both feets. I’m rebuilding my portfolio betting on indexes going up.

doune
doune
11 years ago

Hey ! nice initiative this “course” 🙂

Can we have monthly a course about stocks/financial stuff ?

It will be great.

Noodlehead
Noodlehead
11 years ago

Thanks for the breakdown, I have done very little investing myself and it is becoming more prevalent in my near future.

Chris
Chris
11 years ago

Great article. I love index funds and ETFs. Passive investing is the best way for normal people to make a good return on their investments. Too many people try to speculate in the stock market and they are just not prepared to take the time and energy that is NECESSARY to earn above-average returns.

I use Vanguard as well because their fees are so low. As pointed out in the post, a small difference in the fees associated with the asset make a huge difference in the long run.

Good post ABC

http://behaveyourfinance.com/

rubin pham
rubin pham
11 years ago

index fund is a good way to invest in the stock market. very few people in the world can beat the market as a whole over the long run. warren buffet is one of these.
having say that my investment in vanguard s&p 500 is up a paltry 2.5% in 10 years.

Roscoe Casita
Roscoe Casita
11 years ago

I’m a complete skeptic when it comes to stocks.

They are gambling & speculating on performance.

Index, ETF, Personal pick, Doesn’t matter.

Too many people ‘invest’ in the stock market (Just like the 20’s again), especially with a “Buy and Hold” strategy. (when do you sell?)

While 15% y/y returns appear nice, 40% loss is appalling. I’ll take a 3-4% constant every year instead.

Don’t misunderstand me; I’m learning to be a day trader. I love speculation. Purchasing anything other then a dividend stock is speculation pure and simple.

Dustin Brown
Dustin Brown
11 years ago

I quickly Googled “etf vs index fund” and found this link: http://www.altruistfa.com/etfs.htm It does a pretty good job of explaining ETFs. The only thing that confused me was when at the very beginning of the article, they stated “(…) they are basically just index mutual funds which are bought and sold as stocks.” That made one of my eyebrows rise, because I’m under the impression that with every investment; whether you’re talking about an actively managed mutual fund, an index fund, an EFT, or anything else; when you get down to the core of what is being traded, you’re dealing… Read more »

JC Webber III
JC Webber III
1 year ago
Reply to  Dustin Brown

Not quite. They are saying that EFTs ‘trade’ like stocks. Meaning that you can buy and sell them throughout the day at prices that vary, depending upon the demand for them during that day. Unlike ETFs (or stocks), Mutual Funds trade at the END of the trading day and the price (NAV (Net Asset Value)) is set based upon the closing price of ALL the stocks in that Mutual Fund. The difference here being WHEN the trades are made and HOW they are priced. That’s what they mean when they say “ETFs trades like stocks” instead of trading like Mutual… Read more »

Kyle
Kyle
11 years ago

@Roscoe:

The problem with not taking any risk, is that you can’t get any award. Guess how much return your 3-4% gives you after inflation is taken into account each year? A big whopping 0. Some years you might even lose money (after accounting for inflation).

Sure you can lose in the market too, but history has shown over long periods (> 20yrs) of time the stock market will outperform guaranteed investments significantly.

Dustin Brown
Dustin Brown
11 years ago

You woulnd’t happen to be a broker, would you Kyle? 😉

Roscoe Casita
Roscoe Casita
11 years ago

Kyle: I completely agree, but 3% – inflation > -40% – inflation. (You can also hand pick the 20y time line that shows loss in the stocks.) Most years, when the stocks are on the rise, it CAN be profitable. After this downturn, retirement accounts are down 20-40%. At 10% they should have cut their losses, but MOST people believe “Buy and Hold”. I conjecture that people look at stocks as an investment. I look at them as a speculation & gamble. *I do like the right gambling game* I’m also “fiscally conservative” as 90% of my cash is in… Read more »

Derek Kay
Derek Kay
11 years ago

Warren Buffett highly recommends index funds (over etfs) for the average investor – and Vanguard is hard to beat because of it’s fees. @Stray Cat. Be careful. This is a global stock decline which means there are global effects – think of dropping several stones close together. The waves from one will have an effect on another. While nobody knows for sure, general thought from the academics is that we’re just past the end of the beginning. Of course, they could be wrong. Nobody really knows. This is how I look at it though: When the market turns around we’ll… Read more »

Stephanie
Stephanie
11 years ago

Great post. I have recently invested in an index fund and have been trying to learn more about the process and ups and downs of investment in all areas.

Craig
Craig
11 years ago

Thanks, I actually printed this article out so I can have it for a reference with index funds. I like the basic descriptions for those like myself who are new to investing.

Aman
Aman
11 years ago

I think one things should be made clear, Index funds do not promise any specific return. When investing your own money, you need to be involved in the whole process. My money is treated like little employees, they are all out there in real-estate, invested in small business start-ups, my education, stocks, etc…and I expect that they earn. If not, I transfer them elsewhere. Passive investing may sound like a good idea, but will come with pitfalls…if you pick the wrong index fund and it only goes up a few % each year, then with inflation/taxes/fees you probably are better… Read more »

simplesimon
simplesimon
11 years ago

@Roscoe Buying stocks means you’re investing in a business. The expected return is higher in stocks than in bonds/cash. This downturn has been horrible but it’s a risk premium showing up. Do not accept the premium and not the risk of stocks. You mentioned the 1920’s, and while it did take a decade or two to come back, those that stuck with it have been rewarded tremendously. This is also assuming you’ve been in 100% stocks the entire time. You’re right in that retirement accounts have taken beatings. But if a portfolio for someone that is going to retire the… Read more »

WeSeed Writer
WeSeed Writer
11 years ago

It’s great to see so much enthusiasm for investing on a PF blog. Especially now, when so many people are scared and running away from stocks and index funds.

Roscoe Casita
Roscoe Casita
11 years ago

The yield on the treasury-bill is around 4% right now (lower as the treasury prints more money). As for risk aversion, yes very risk adverse as my net portfolio is VERY low (<10k). I agree that if you took a -40%, your were in to high of risk to begin with. As for ownership in a company, unless you have lots of $, or control the majority of stocks, you still don’t really have a say in the companies doings. If you don’t have a say(realistically), it doesn’t pay a dividend, and your not actively trading (Buy and hold): then… Read more »

Suzanne
Suzanne
11 years ago

JD: Great guest post. I would love to see more from ABC’s.

ABC’s: I just found your site this week on another blog and I’m definitely learning. Thanks!

Nick
Nick
11 years ago

I agree that diversifying is important, but index funds are a good place to start making money in the market. I mean, you’re never going to have a monumental gain that you will may have with an individual stock, but chances are you will have a steady gain throughout most of the life of your investment.

Brint
Brint
11 years ago

I’ll dissent here. In normal times, index funds were a safe way to average out a good return over several years. These are not normal times. Anyone with money in stocks right now (or long-term T-bills for that matter) is playing with fire. Put it on the sidelines until the turmoil is worked out. CDs or short treasury funds or MM funds. Deflation and recession will cause stocks to drop another 20% from here before bottom. We could be at the beginning of a lost decade (or two) for stocks. Or the Masters of the Economy could overcompensate and dump… Read more »

Tea
Tea
11 years ago

The odds are worse than most people realize. The majority of stocks underperform the market. I believe the ratio is about 64% of stocks underperform large index funds. That means that the odds of underperforming the market with a small selection of equities (that an individual investor would probably have) are rather high. This doesn’t mean that I’m against equities. The above statistic also shows that stocks that outperform frequently do so by a large margin. I’m actually 100% individual stocks right now. My point is just that research is incredibly important when working with equities. It amazes me how… Read more »

Aman
Aman
11 years ago

@Brint Speak for yourself before generalizing on how others are fairing in the stock game. If you feel you are an expert, kudos, but a lot of us that post and comment are doing fairly well and know more than you might want to believe. And what advise are you giving when saying that its not a time to play the market. If you find downtrends, ride the short train downwards OR if your long, buy the stock..some of us are making an income. There is no playing with fire involved when we can pick up GM for 2.99/share and… Read more »

Roscoe Casita
Roscoe Casita
11 years ago

@Aman:

I think you’ve hit upon a fundamental topic; people “invest” in the stock market without knowing anything about it.

Embracing Risk & Responsibility is NOT in most peoples interests: How many times do you here “It’s not my fault!” and that makes it O.K.

As a side note: Why is personal finance excluded from High School? (Conspiracy to keep you down! J/K)

(Here’s a rather interesting Stock Blog: http://evilspeculator.com/)

willamettejd
willamettejd
11 years ago

I’m a big fan of index funds, but they are not a retirement panacea. The thousands of retirees out there who saw their retirement accounts lose 40% in the last year are a testament to that. True diversification requires more than just stock investing: remember that index funds only go up when the entire economy goes up – and we have happened to enjoy a 25 year joyride of amazing overall market returns. Index investors between 1930-1980 earned PALTRY returns that much of the time did not even beat inflation. True diversification means asset diversification. My favorites: split your retirement… Read more »

Frugal Bachelor
Frugal Bachelor
11 years ago

Why do all discussions about index funds center around S&P 500 (or, worse, DJIA)? Those are American indexes, and thereby exclude 95% of the global population. For that reason they seem atypical, if not cherry picked. I know the markets of the second and third largest economies on the planet (Japan & Germany) have not performed nearly as well, and have had significant periods of stagnation. It seems, with increased globalization, that international markets would give more accurate precedence regarding long-term market trends. What are the average returns for a global stock market index (by definition the most ‘neutral’ stock… Read more »

Sara
Sara
11 years ago

People keep referencing “Vanguard index funds” but I can’t figure out what these are? Can anyone name them for me? Any specific recommendations? Thanks!

J.D.
J.D.
11 years ago

It sounds like there’s a lot of interest in future coverage about index funds and other investment topics. I’ll try to cover these more in 2009. I think it would be educational for me, as well as others. Sound good?

JC Webber III
JC Webber III
1 year ago
Reply to  J.D.

Did you mean 2019 or am I reading a REALLY old post?

TimK
TimK
11 years ago

Active vs Passive is one of the fundmental decisons to make after defining an appropriate asset allocation. Would you rather pay a fund manager 0.5% to 1% of returns to try and beat “the market” or would you rather accept the retruns of “the market” and minimize your costs? Vanguard Total Stock Market ETF charges a rock bottom 0.07% expense ratio. “The market” is a market capitalization weighted index. For example the top 5 holdings of the Vanguard total stock index are: ExxonMobil 3.22%, General Electric 2.0%, Microsoft 1.76%, Proctor & Gamble 1.67%, Johnson & Johnson 1.53%. Exxon price per… Read more »

Spaceknarf
Spaceknarf
11 years ago

For anyone in the Netherlands who is interested in buying index funds: as far as I know the easiest and cheapest way to do that is through SNS Fundcoach ( http://www.snsfundcoach.nl ). You can buy several of the Vanguard funds there. (I’m not an employee of Vanguard or SNS 😉 )

J.D.: it seems people are interested in the practicalities of buying index funds (more like a step-by-step guide of actually buying them).

Wise Investor
Wise Investor
11 years ago

Just a quick point or two:

1. While most passive investing utilizes index funds, ‘indexes’ and ‘passive’ are not synonymous — many people employ a relatively active trading strategy using ETFs or index funds.

2. I, as many others have done, heartily recommend the Bogleheads Board at:

http://www.bogleheads.org/forum/index.php

for terrific information, and to get any questions answered regarding *both* of the separate topics of passive investing and indexes.

Rob Bennett
Rob Bennett
11 years ago

The definition being given to “Passive Investing” in the words above is the most common one. I do no think it is a good one. I believe that the common definition mixes two concepts in a dangerously misleading way. The indexing concept is wonderful. Indexing permits the investor to achieve a high level of diversification at low cost. That’s the answer for the vast majority of middle-class investors. So I share the blog author’s enthusiasm for the indexing concept. I do not think that the “passive” part of Passive Investing is at all a good idea, however. The thing that… Read more »

Peggy
Peggy
11 years ago

Hm, this whole topic…

I see…(blank stare)

I tend to invest in things that don’t require a separate vocabulary.

simplesimon
simplesimon
11 years ago

@Sara: Vanguard refers the mutual fund company. Index is the type of fund (as discusses in length in these comments.) As for recommendations, it depends on what type of fund you want: U.S. Stocks – VTSMX (Vanguard Total Stock Market Index Fund) International Stocks – VGTSX (Vanguard Total International Stock Index Fund) Bonds – VBMFX (Vanguard Total Bond Market Index Fund) And there are many others. @JD I originally found this site from a list I got from googling “most popular finance blogs.” There must be such a huge reader base that a good portion probably doesn’t know too much… Read more »

vilkri
vilkri
11 years ago

Index fund are such a compelling story for the average investor that I wonder why they are not even more popular. I guess the only reason must be the higher sales commission brokers get when they put their clients’ money into actively managed funds which charge much higher fees.

Jeremy
Jeremy
11 years ago

@Sara: http://www.vanguard.com/ is a Mutual Fund family (big company with lots of different funds) that makes a point of low fees so you keep more of what they earn. I guess my take on what to invest in depends on the time/expertise you have. If you had 1 hour a year you wanted to spend on investing, I’d say call a broker and set an appointment. Go for buy ‘n’ hold ‘n’ hope. If you want to spend 10 hours a year, then you can get into ETFs, and spend your time picking areas you like and rebalancing yearly. If… Read more »

Sassy and Retired
Sassy and Retired
11 years ago

Recently I learned about Mr. Bennett, who is quoted above saying: “I endorse a reformed approach to indexing…”

The internet has no requirement that people giving advice have any proven credentials or capability, and thus we find Mr. Bennett acting as if he is an authority, when the reality is that a short visit to listen in on some of the fifty or so audio files on his website will quickly establish him to be a crank with an old and long rusted axe to grind. Be careful of the advice you listen to out there!

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