Index funds let you invest in the stock market without facing the challenges and risks of investing in individual stocks. Index funds allow investors to focus on specific sectors of the stock market, or -- in the case of broad-based funds -- participate in the average returns of the entire stock market with a single investment.
Index Funds: No Thinking Involved
An index fund owns shares of stock to match the stock values tracked by a particular stock market index. For example, a DJIA fund will own the 30 stocks included in the calculation of the Dow Jones Industrial Average. The management of an index fund does not analyze stocks to try to beat the market. Instead, the only function of fund management is to buy or sell shares to keep the weighting -- or total value of the shares -- of each individual stock to match the weight used by the company running the index to calculate the index's value.
Companies Big and Small
A broad market stock index attempts to include the value of nearly every stock trading on the stock exchanges when calculating the index value. The popular broad coverage indexes track the value of between 3,000 and 5,000 stocks. Broad market indexes use individual company values -- called market capitalization -- to determine how to weight each stock in the index. This means the share values of the several hundred largest companies in the U.S. have the most effect on this type of index, while the 1,000 or more small companies at the end of the list have little effect on the index value.
ETFs vs. Mutual Funds
Index funds come in two types: exchange-traded funds and mutual funds. Funds of both types are available that track the most popular broad market stock indexes. ETF shares trade on the stock exchanges and are bought and sold just like individual stock shares. With a mutual fund, you can set up an account and invest directly with the fund company or make your investment through a broker. Mutual funds are designed for buy-and-hold investment strategies. ETF shares can also be purchased for the long haul, or you can move in and out of ETFs more quickly if you want to time the stock market swings.
The Couch Potato Investment Strategy
Use a broad market-based index fund to get stock market investment exposure with a single investment. Investing a broad-based stock fund along with a total market bond fund allows you to set up a simple asset allocation investment strategy where your only action is to rebalance between the two funds once, twice or possibly four times a year. The asset allocation investment strategy takes very little time and allows you to move money between stocks and bonds with the forced purchase of the two major asset classes when prices are low and sell them when values are high.
Tim Plaehn has been writing financial, investment and trading articles and blogs since 2007. His work has appeared online at Seeking Alpha, Marketwatch.com and various other websites. Plaehn has a bachelor's degree in mathematics from the U.S. Air Force Academy.