Index funds: A beginner's basics
An index fund is a special type of mutual fund that tracks the returns of a broader market index, such as the S&P 500, Russell 2000 Index, NASDAQ Composite Index, Dow Jones Industrial Average (DOW), etc. Think of index funds as a basket holding many different stocks, cash, bonds or other securities. Like mutual funds, index funds are characterized by a ticker symbol to distinguish it from other index funds. For example, FXAIX (Fidelity 500 Index Fund), SWPPX (Schwab S&P 500 Index Fund), PREIX (T. Rowe Price Equity Index 500 Fund) are 3 examples of index funds that track the S&P 500.
Why investors buy index funds
Investors invest in index funds for various reasons. They invest in index funds to create wealth, achieve financial stability and independence, plan for retirement, vacation, or education. Because they are usually passively managed, meaning fund managers are not actively researching, picking and selling securities, they incur less cost to investors. A single index fund can include all the stocks or securities of an index (S&P 500) or a good portion of it. Check out why Warren Buffett loves index funds!
How to purchase index funds
You can buy index funds from a broker for the fund (Fidelity, E-trade, TD Ameritrade, etc.) or the fund itself. Investors buy index funds at the fund's net asset value (NAV). The NAV is nothing more than the amount of money you need to buy one share of the fund. Here are the steps you need to take to buy index funds: 1) open a brokerage account; 2) fund your account; 3) decide how many shares of the index fund you want to buy; 4) choose your order type; 5) complete the order, sit back and celebrate. Although index funds are less risky investments compared to stocks, you should always read the fund's prospectus, a document that outlines the fund's investment strategy, fees, risks, among other things. Here's a nice little guide on how to evaluate and select index funds for your portfolio.
Benefits and risks of index funds
As an investor, owning index funds comes with risks and benefits. If the index fund's price or net asset value (NAV) goes down, you will lose money and vice versa. There is no certainty that companies whose stocks the index fund holds will prosper or do well. To a large extent, an index fund's NAV is dependent upon the basket of securities (stocks, bonds, cash, etc) it holds. Many factors affect an index fund's share price (NAV), including but not limited to quarterly earning reports of individual companies, regulatory, political, economic and other events.
How you make money from index funds
First, you make money when the index fund's price goes up or through capital gains. You also make money by earning dividends. Dividends are usually paid to shareholders quarterly. Not all companies pay dividends. Index funds are meant to be kept for the long-term. Here's a nice overview of how investors earn money from index funds or mutual funds. Check out a nice comparison between stocks, ETFs and index funds.