Index funds and ETFs: buying the whole basket
Instead of picking one needle, you can buy the whole haystack.
What a fund is
A fund pools money from many investors and buys many investments at once. With one purchase you can own a small slice of hundreds or thousands of companies.
An index fund simply tries to match an index, such as the S&P 500, by holding the same stocks in the same proportions. No one is trying to pick winners, which keeps costs low. Funds where managers pick investments are called actively managed funds; research has repeatedly found that most of them trail their index over long periods, especially after fees.
ETFs vs mutual funds
An ETF (exchange-traded fund) trades on an exchange like a stock: its price moves during the day and you buy it through a broker. A traditional mutual fund is priced once a day after the market closes. Both can be index funds. The differences are mostly about how you buy them, minimum investments and, in the US, some tax details.
SPY, VTI and QQQ, which you can trade in the app's paper trading, are ETFs that track the S&P 500, the whole US market and the Nasdaq-100 respectively. Mentioning them is not a recommendation; they are just well-known examples.
The trade-offs
Index funds give you the market's return, minus small fees. That means you'll never beat the market, but you're unlikely to fall far behind it. You also get whatever the index holds, including its booms and busts. A narrow index, like one sector, is less diversified than a broad one.
Put $1,000 in one company's stock. If it falls 50% you have $500.
Put $1,000 in a fund holding 500 companies, each a small slice. If one company falls 50% and it was 1% of the fund, that costs you about $5 (1% of $1,000 is $10, half of which is lost). Your result depends on how the whole group does, not one company.
Key terms
- Index fund
- A fund that tries to match the performance of an index by holding the same investments.
- ETF
- Exchange-traded fund: a fund that trades on an exchange like a stock.
- Mutual fund
- A pooled fund usually bought directly from the fund company and priced once a day.
- Active fund
- A fund whose managers pick investments trying to beat the market.
An index fund lets you own a whole market in one purchase, at low cost.