Index Funds

Index funds are mutual funds that invest in all the stocks in a particular stock index. For example, a mutual fund that uses the Standard and Poor's 500 stock index would buy stock in all the companies that make up the index. If you invest in an index fund, your returns would match the returns of the index your fund is based on.

Technically, index funds are not really a type of mutual fund because they are comprised of different types of funds (for example, growth funds and sector funds) chosen from one particular index. In a literal sense, investing in index funds is more about how you invest rather than what you invest in.

Why index funds are a popular mutual fund investment. For many people considering their choices in investment vehicles, index funds are a popular method of investing in mutual funds. There are two main reasons why. First of all, almost every year, the rate of return of the bigger stock indexes, such as Standard and Poor's 500, is equal to or higher than the rate of return of most funds chosen by financial professionals. Investing in an index fund is a good way to come as close as possible to ensuring that your returns won't fall below the market averages. As always however, chances are also very good that your returns from an index fund will not be spectacular because you trade safety for greater gain.

The second reason investors choose index funds is because the investment management fees are much lower than for other funds. There's no real input on the part of the financial professional as to what the fund should buy or sell, since it is dictated by the index.

Tip Keep in mind that by simply investing in an index fund you are not necessarily diversifying your investments. For example, if you invest in an index fund based on the Dow Jones Industrial Average or another index limited to a specific market, you are not diversified, even though your fund is investing in more than 50 different stocks.