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Index fund investorWhen you buy stock in a company, you hope that the underlying company will do well and cause the share price to rise. When you invest in an index fund, you hope the entire sector of the market that the index tracks will do well and cause all of the companies in it to gain value, thus boosting the value of your index fund holdings. That’s the difference between index funds and stocks in a nutshell. Now let’s dive into the details.

Consider working with a financial advisor to find the best mix of individual shares and index fund holdings for your portfolio.

What Is An Index Fund?

An index fund is a portfolio of assets held and managed by an investment firm. Generally it will be made mainly (or entirely) out of stocks and corporate bonds. Like stocks, you invest in an index fund by purchasing individual shares. You then own a percentage of the overall portfolio equivalent to how many shares you bought and are entitled to the fund’s returns on that pro-rata basis.

For example, say that the ABC Fund releases 50% of its value in the form of 100 shares. This means that the firm which manages the fund has retained ownership of half of the portfolio. The other half it has offered to investors. If you buy one share of this fund, you own 0.5% of the overall portfolio and are entitled to 0.5% of its returns.

This is the basic structure of what is called a fund-based asset, which firms typically sell as mutual funds and ETFs.

An index fund is a specialized form of fund-based asset. With an index fund, the managing firm selects the portfolio’s assets to match the index that tracks a specific segment of the market. The idea is that firm will peg its fund’s performance to a specific idea, industry, sector or other market metric.

The goal of the fund is to match the index’s performance. This is as opposed to many fund-based assets, which are built to simply generate returns or mitigate risk regardless of the market as a whole. Indeed, unlike other types of assets, an index fund that loses value is often working exactly as designed. For example, a firm might build an index fund around the technology sector. This means that the fund tracks the performance of technology stocks as an industry. If tech companies do well and gain value, the index fund will gain value, too. If tech companies hit a rough patch and their prices fall, the index fund’s value will fall – by design.

To do this, the firm running an index fund will build its portfolio out of assets relevant to the performance of its chosen metric. For example, a firm that builds a technology sector index fund might build a portfolio out of technology company stocks, bonds issued by technology companies and any other assets that it feels reflect the performance of the tech sector as a whole. For example, depending on the fund, this firm might purchase options contracts in gold, silicon and other semiconductors. Or it might invest in logistics companies known to work heavily with technology companies.

The exact composition of an index fund is up to the firm running the fund, and investment firms work very hard to create the right formulas for an index fund that succeeds in tracking its industry’s value. However, the overall principal is consistent: An index fund is built out of assets that the firm believes represent that value of a market segment.

The most popular index funds track major sections of the market. This particularly includes:

  • Market indexes, such as the S&P 500 and Dow Jones Industrial Average, where an index fund will track the value of these market metrics; and
  • Industry indexes, where a firm will build its index fund to track the value of an industry as a whole, such as retail, technology or energy.

How Index Funds Differ From Stocks

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A stock, meanwhile, is an ownership stake in an individual company. By purchasing a stock you have literally bought a fractional ownership in the underlying business. For example, say a company releases its entire value for sale in 100 shares of stock. If you buy one share of that company’s stock, you now own 1% of the company itself. Depending on how that business manages its stock, this might entitle you to a share of its profits in the form of dividends. It also can entitle you to a voice in governing the business based on how many shares of stock you own. (Of course, given that major firms can release billions of shares, it takes a significant investment before you can get a meaningful voice in the affairs of a publicy traded corporation.)

Mostly you profit off of a stock through what’s called capital gains. When the company does well, other investors take an interest in it. This increases demand for the company’s stock, which in turn increases its price in the market. If that price goes up while you hold the stock you can sell your shares for more than you paid to buy them, making a profit. Stocks can also pay returns in the form of dividends, when the company pays its shareholders a portion of the corporate profits.

Whatever the details, with a stock ultimately you make your money off of a single company’s performance.

Index Funds vs. Stocks

The biggest difference between investing in index funds and investing in stocks is risk.

Individual stocks tend to be far more volatile than fund-based products, including index funds. This can mean a bigger chance for upside … but it also means considerably greater chance of loss. By contrast, the diversified nature of an index fund generally means that its performance has far fewer peaks and valleys. Like all fund-based products, an index fund holds a large number of different assets in its overall portfolio. Instead of investing in just one stock, as you will with a stock, you are investing in dozens (if not hundreds) of stocks, bonds and other assets.

This means that even if one company loses value, there’s usually another company to make up that performance. Of course, if one company posts huge gains, those returns will be watered down by the rest of the portfolio as a whole.

The diversification of an index fund depends on the nature of the fund itself. A fund which invests in a specific industry or market sector will be less diverse than a fund which invests in the market as a whole. For example, you might invest in a technology sector index fund and an S&P 500 index fund. It’s easier for something to happen (good or bad) to the technology sector specifically than for something to happen (again, good or bad) to the entire stock market.

An industry can dip or boom more easily than the whole market can slide into recession or surge.

Index Fund Advantages

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For an individual investor, index funds generally have two major advantages over investing in an individual stock. First, ignore what some other financial websites have written about control over your holdings and the personal satisfaction of financial success. Very few investors ever beat the market. This is true even among the pros. Studies consistently find that more than 90% of professional investors cannot pick stocks that do better than the market as a whole in the long run.

Take two investment portfolios. Put nothing but an S&P 500 index fund in one of them, then actively buy and sell stocks in the other. Your index fund will be worth more year-over-year almost every time. This isn’t an ironclad rule, but nine times out of ten you will make more money with index funds.

Second, an index fund reduces complexity. Investing in the stock market means tracking performance, following company fundamentals, reading earning statements and much, much more. This is a difficult thing to do well and it can quickly eat up your time and attention. Investing in an index fund is a passive investment strategy. You buy the asset and then leave it alone to collect value and generate returns. There’s no need to follow performance or play the stock market.

Investing with stocks is not unwise. In fact many investors enjoy active investing. They find that it’s a thrill to try and beat the market. However, like all speculative assets, you should make sure that individual stocks only make up the speculative part of your portfolio. Invest in these assets with money you can afford to lose. For the long-term, stable segment of your portfolio, index funds are often an excellent idea.

The Bottom Line

A stock gives you one share of ownership in a single company. An index fund is a portfolio of assets which generally includes shares in many companies, as well as bonds and other assets. This portfolio is designed to track entire sections of the market, rising and falling as those segments do.

Tips on Investing

  • Should you take more risks? Is it time to start playing it safe? We can’t tell you that here, but it’s exactly the kind of conversation you can have with a smart financial advisor. Finding one doesn’t have to be hard. SmartAsset’s matching tool can help you find a financial professional in your area to help you with questions like these … and many more. If you’re ready, get started now.
  • Deciding between stocks and index funds isn’t the only choice careful investors face. Among other challenges is getting a good estimate of how your portfolio will do over time. That’s where a free investmenet calculator can come in handy.

Photo credit: ©iStock.com/Moon Safari, ©iStock.com/peshkov, ©iStock.com/damircudic

Eric Reed Eric Reed is a freelance journalist who specializes in economics, policy and global issues, with substantial coverage of finance and personal finance. He has contributed to outlets including The Street, CNBC, Glassdoor and Consumer Reports. Eric’s work focuses on the human impact of abstract issues, emphasizing analytical journalism that helps readers more fully understand their world and their money. He has reported from more than a dozen countries, with datelines that include Sao Paolo, Brazil; Phnom Penh, Cambodia; and Athens, Greece. A former attorney, before becoming a journalist Eric worked in securities litigation and white collar criminal defense with a pro bono specialty in human trafficking issues. He graduated from the University of Michigan Law School and can be found any given Saturday in the fall cheering on his Wolverines.
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