An index fund buys the same stocks as the index it follows. For example, an S&P 500 fund buys all the stocks of the S&P 500 Index. That means the fund will perform the same as the index performs. If you buy such a fund, you save the time, trouble and expense of having to pick individual stocks, but you also guarantee you won't do any better than the index does.
All in the Same Boat
When you own shares of an index fund, you do about as well or poorly as everyone else in the stock market does. When the markets go down, you may find some comfort in knowing that it's not the result of your failure to pick good stocks. If you're losing money, everybody's losing money. If the markets go up, you have the comfort of knowing you are in on the trend and are prospering along with the rest of the market.
Because index fund managers don't have to search for stocks, you pay lower fees for their management expertise. They simply buy stocks in the same proportion as the underlying index has purchased them. If the index changes stocks, the fund changes stocks.
Beat the Managers
According to Seeking Alpha and "U.S. News and World Report," most fund managers who pick their own stocks don't beat the indexes. By buying shares in an index fund, you stand a good chance at doing better than active fund managers who spend their days combing through the markets for the next big winner.
Because you must pay management fees to your index fund, you will actually do a little worse than the index does. The fund will take out part of the profits to pay the fees. Of course, you probably couldn't afford to buy every stock in an index anyway, so the slight under-performance may be worth the convenience of owning so many stocks at once with one simple purchase of index fund shares.
No Huge Winners
If you like the stock market for the excitement of big gains, index funds may not be for you. Because your money gets spread out among so many stocks in the index, even if one stock does exceptionally well it won't cause a huge spike in your index fund value. To own an index fund, you must be satisfied with a slow and steady earning pace.
Kevin Johnston writes for Ameriprise Financial, the Rutgers University MBA Program and Evan Carmichael. He has written about business, marketing, finance, sales and investing for publications such as "The New York Daily News," "Business Age" and "Nation's Business." He is an instructional designer with credits for companies such as ADP, Standard and Poor's and Bank of America.