Talking Cash: Untangling index funds
If you're unfamiliar with them,
index funds can be a bit difficult to
untangle. In order to understand
what they are, you have to be
familiar with both mutual funds
and stock indexes.
Mutual funds are basically groups of stocks put together by a financial institution. They could be a group of stocks in a certain industrial sector (i.e. energy, medical, technology, etc.), or they could be a group of stocks that pay dividends, or are only from a certain country, or are just handpicked by the person managing the fund as being potential big gainers in the future. When you invest money in a mutual fund, you are buying a small share of the entire group of stocks in the fund.
A stock index is exactly what it sounds like: a list of stocks. There are companies that specialize in financial analysis that maintain lists of what they think are the best stocks available for trade in a country or on a certain exchange (such as the New York Stock Exchange or the Toronto Stock Exchange). The most prominent examples of indexes are the S&P 500 and the Dow Jones Industrial Average. The S&P 500, for example, is a list of the 500 best stocks and is maintained by the financial analyst company Standard & Poor's. They basically select what they think are the best 500 stocks trading in the U.S. and update the list regularly. In Canada, the most prominent index is the S&P TSX Composite.
Indexes are pretty important when it comes to financial analysis, particularly in the media. When you read in the news that a certain stock has beat the market, or that the market was done at the close of business today, they're generally referring to the combined price of the Dow Jones or the S&P 500 in the U.S., or the S&P TSX Composite in Canada. Thus, typically the goal of people managing mutual funds, or people buying stocks, is to beat these indexes, since they set a benchmark for performance in the stock market.
Now we get to index funds, which, quite simply, are mutual funds where the group of stocks in the fund mirrors a particular index. So, an index fund that mirrors the Dow Jones will include the same 30 stocks that are listed in the Dow Jones. If the Dow Jones changes, so does the fund. The same can be done with virtually any index, be it the S&P 500, the S&P TSX Composite or whatever. The fund merely tracks the index and if the index removes a certain stock and adds a new one, so does the fund. Thus the return on your money will match the performance of the index.
Index funds have become popular because, as is widely known, picking stocks or even mutual funds can be a bit of a crapshoot. No one can predict the future, no matter how much analysis one performs. With an index fund, you're basically getting returns based on the best stocks in the market. If these stocks perform well overall, you'll get a good return. If these stocks do poorly, such as in the 2008 market crash, you'll do poorly, too. Overall, the market for the best stocks is fairly stable, so by investing in index funds you're essentially mitigating risk by taking in lower returns than you would if you were able to pick stocks that beat the market.
Jeremy Wall is studying Professional Financial Services at Fanshawe College. He holds an Honour's Bachelor of Arts from the University of Western Ontario.
Mutual funds are basically groups of stocks put together by a financial institution. They could be a group of stocks in a certain industrial sector (i.e. energy, medical, technology, etc.), or they could be a group of stocks that pay dividends, or are only from a certain country, or are just handpicked by the person managing the fund as being potential big gainers in the future. When you invest money in a mutual fund, you are buying a small share of the entire group of stocks in the fund.
A stock index is exactly what it sounds like: a list of stocks. There are companies that specialize in financial analysis that maintain lists of what they think are the best stocks available for trade in a country or on a certain exchange (such as the New York Stock Exchange or the Toronto Stock Exchange). The most prominent examples of indexes are the S&P 500 and the Dow Jones Industrial Average. The S&P 500, for example, is a list of the 500 best stocks and is maintained by the financial analyst company Standard & Poor's. They basically select what they think are the best 500 stocks trading in the U.S. and update the list regularly. In Canada, the most prominent index is the S&P TSX Composite.
Indexes are pretty important when it comes to financial analysis, particularly in the media. When you read in the news that a certain stock has beat the market, or that the market was done at the close of business today, they're generally referring to the combined price of the Dow Jones or the S&P 500 in the U.S., or the S&P TSX Composite in Canada. Thus, typically the goal of people managing mutual funds, or people buying stocks, is to beat these indexes, since they set a benchmark for performance in the stock market.
Now we get to index funds, which, quite simply, are mutual funds where the group of stocks in the fund mirrors a particular index. So, an index fund that mirrors the Dow Jones will include the same 30 stocks that are listed in the Dow Jones. If the Dow Jones changes, so does the fund. The same can be done with virtually any index, be it the S&P 500, the S&P TSX Composite or whatever. The fund merely tracks the index and if the index removes a certain stock and adds a new one, so does the fund. Thus the return on your money will match the performance of the index.
Index funds have become popular because, as is widely known, picking stocks or even mutual funds can be a bit of a crapshoot. No one can predict the future, no matter how much analysis one performs. With an index fund, you're basically getting returns based on the best stocks in the market. If these stocks perform well overall, you'll get a good return. If these stocks do poorly, such as in the 2008 market crash, you'll do poorly, too. Overall, the market for the best stocks is fairly stable, so by investing in index funds you're essentially mitigating risk by taking in lower returns than you would if you were able to pick stocks that beat the market.
Jeremy Wall is studying Professional Financial Services at Fanshawe College. He holds an Honour's Bachelor of Arts from the University of Western Ontario.
