Stock picking is a hard business. Not only do you need to select winning stocks, but you also need to time your purchase correctly. Even the best stocks go through steep drawdowns and knowing when to sell is just as important as finding winners in the first place. But if you struggle to pick stocks, don’t despair.

‘If you can’t beat them, join them’ usually isn’t a strategy that will win you many friends, but it can be a successful strategy for stocks. Instead of trying to buy and sell winners, why not just own the whole market? That’s where index funds come in. Index funds are passively-managed stock funds which means they attempt to mimic a specific stock index, not pick the best stocks of the lot. By owning an index fund, investors can reap the rewards of all the winners while minimizing the impact of the losers.

The First Index Funds

Vanguard founder Jack Bogle is credited with developing the first index fund. Bogle theorized that the average investor would be better off owning a market index instead of paying a mutual fund manager for their stock picking expertise. Bogle realized early in his career that most active mutual fund managers couldn’t beat the S&P 500 consistently, yet they still raked in large fees for their services.

Bogle founded the Vanguard Group and launched the first index fund in 1976, the Vanguard Index Trust 500. The fund simply tracked the S&P 500 index and tried to equal the return of the market. Bogle’s fund charged minimal expenses, and investors were able to compound their savings. Over time, the average investor would do better than the professional fund manager simply by holding a stock index and saving on fees. Sure, some managers like Peter Lynch broke the mold and beat the market over time, but these guys are few and far between – and most of them aren’t interested in taking your money anyway.

Types of Index Funds

Bogle’s fund tracked the S&P 500 as a whole, but today’s index funds can be much more targeted. Index funds can be found in both mutual funds and exchange-traded funds now, with index ETFs providing some of the lowest expense ratios in the industry. Mutual funds can only be traded at the end of the day, but ETFs can trade on exchanges like stocks.

Index funds can be created around a number of different stocks or sectors. The only criteria is that they track an index – no active manager picking stocks. The fund automatically buys and sells stocks based on the weight of the underlying index. Here are a few of the most common types of index funds:

Broad Market Index Funds – Some of the cheapest and most liquid index funds track broad swathes of the market. You can invest in indices like the S&P 500, Dow Jones, NASDAQ, or include the entire US stock market. Even global stock market index funds can be purchased at most brokers.

Sector-Specific Index Funds – If you want to tailor your investment to specific industries, there are plenty of index funds available that invest using a sector-based index. Sector index funds are a little more expensive than broad market funds, but are still cheaper than your average actively-managed fund. Some of the more common investment sectors with index funds include finance, technology, healthcare, industrials, real estate, and utilities.

Index Funds by Company Size – Index funds can be narrowed down to include or exclude companies based on market cap. Market cap is the total combined value of all shares (stock price + number of shares outstanding), which is used as a proxy for company size. Small cap companies are known to be riskier, while large cap companies are developed firms with safe reputations. Most index funds break down company size into three weights: small, mid, and large.

Where to Buy Index Funds

Index funds are cheap and easy to maintain. Investors using index funds don’t need to check their stocks on a daily basis and only need to rebalance their portfolio a few times per year. This ‘set it and forget it’ feature of index funds makes them ideal for retirement accounts like IRAs and 401(k) accounts, where we hope to let compound interest go to work and compile a large nest egg.

Thankfully, index funds are readily available at all major brokerage firms. Many brokers like Fidelity, Schwab, and Vanguard issue their own index funds with competitive fees and similar fund structure. If you want to take some of the stress and hassle out of your investing, consider building a portfolio of index funds. You might even wind up outperforming the professionals.

Disclosures

The opinions voiced are for general information only and are not intended to provide specific advice or recommendations for any individual.

All investing is subject to risk, including the possible loss of principal. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income. Diversification does not ensure a profit or protect against a loss.