Index Funds Explained for Complete Beginners

Investing into an index fund is one of the best and most powerful ways to build long term wealth within the stock market so today, I wanted to make a post explaining:

1. What exactly is an index fund.
2. What are the main benefits in owning one.

What is an Index Fund?

Alright, so basically, When you invest into an individual company, let’s say Apple or Facebook, you are basically buying a small piece of that business. You buy your share for a certain price, and then if that share price was to go up, you could potentially sell that share for a profit.

Now, when you invest into an index fund, what you are essentially doing is buying a collection of companies instead of just 1 and most of the time, people will buy a collection of stocks from a certain market index, which is where the name index funds come from.

For example, you or may not have heard of the S&P 500. This is basically an index that tracks the top 500 companies in the United States.

So if you wanted to buy an index fund that tracked the S&P 500, you would be buying a small chunk of every company in that index instead of just buying a larger chunk of just 1.

In addition to investing into the more broader index, you can also find sector based indexes that are tied to specific industries. 

For example, if you were interested in investing into the technology sector and you could buy into a technology based index fund where every company in that index fund was in the tech sector.

One final thing to mention is that index funds are passively managed as proposed to actively managed.

An actively managed fund is basically when someone is trading your money for you on a day to day basis and trying to beat the market where as an index fund passively just tracks the market and is not traded on a day to day basis.

Overall, an index fund is basically a collection of stocks instead of just 1.

Let’s now move onto some their benefits.

What are the benefits of investing into Index Funds?

Extremely low fees.

Okay, so the first main benefit of owning an index fund are the low management fees associated with them.

Taking a look at an actively managed fund, because they have people and bots actively trading stocks every day for them, the costs are simply just going to be higher because at the end of the day, they have to get paid one way or another.

And boy do they get paid!

However, because index funds are passively managed and zero trading is taking place, they of course required a lot less people to look after them which then in turn leads towards much lower fees, saving you a lot of money!

Just using this chart above as an example, we have both a passive index fund and actively traded funds performance on the S&P 500 between 1980 & 2015.

The index fund has a 0.06% fee and the active fund has a 2.27% fee and as you can see, the difference in how much extra money you can make over a long period of time, just by saving on fees is quite the amount.

Less risk than owning individual stocks.

The second main benefit is that owning an index fund is much less riskier than owning just 1 stock.

Let’s just say you owned $100,000 worth of a single company and for one reason or another, that company went bankrupt and their stock price went to 0. In terms of your investment, unfortunately you would be left with nothing.

However, let’s say you investing into an index fund that tracked the entire S&P 500 and you owned a little bit of every company in that market, if the same was to happen to one of the companies you owned stock in, you still then have another 499 companies that you’re invested in and the likely hood is, you wouldn’t even notice it!

Less time required researching which fund to invest in.

When you invest into an individual company, you need to understand the business inside out. You need to research previous balance sheets, check  income statements, look at how the company can grow and the list pretty much goes on.

However, with an index fund, you don’t research the companies because of course that would be ridiculous. Instead, you invest a set amount each month over a long period of time and forget about it.

The best way I like to explain this is with an individual company, you are betting that the business you own will go up. With index funds, let’s say you owned an index fund of the S&P 500, you are basically betting on America.

Where do I start?

If you wanted to invest into an index and you didn’t know where to start, I have listed below some investing apps in which you can do that, but my personal favourite is free trade who actually have a dedicated section for index funds and they provide a really great and easy to understand description of each one.

also, if you were to actually sign up to FreeTrade with my link below and deposit £1 onto the platform, you will actually receive a  worth anything between £3 and £200 as a welcome bonus.

Finally, if you enjoyed this article, then I would highly appreciate it if you checked out some more below, or maybe took a trip over to my YouTube channel to take a look at some videos.

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