A stock index is a collection of stocks whose value is a benchmark for the overall movement of a particular type of stock. It is used as a tool to represent the characteristics of all the stocks included in that particular group, all of which bear something in common such as trading on the same stock market exchange, belonging to the same industry, track companies of a certain size, a certain type of management, or even more specialized criteria, or having similar market capitalizations. Examples of indices include the S&P 500, the Dow Jones Industrial Average, and the Nasdaq Composite Index.
Many investors choose to invest in stock index funds because they allow you to enjoy the advantages of a mutual fund without experiencing all the disadvantages a mutual fund has to offer.This is because they are able to buy stock in all the companies of a particular index and thereby reproduce the performance of an entire section of the market. An index fund builds its portfolio by buying all the stocks in a particular index, not just a few stocks.There are index funds that track 28 different indexes with more being added all the time.The most popular index of stock index funds is the Standard and Poor’s 500 or S&P 500.
The key distinction between stock index funds and “actively managed” mutual funds is that the manager of a stock index fund doesn’t have to worry about which stocks to buy or sell because he or she only has to buy the stocks that are included in the fund’s chosen index.For example, an S&P 500 stock index fund owns 500 stocks, which are all the companies that are included in the index.Also, a stock index fund has no need for highly-paid stock analysts and expensive computer equipment that chooses stocks for the fund’s portfolio, so the difficult part about running a mutual fund is gone.
Investing in stock index funds is often referred to as passive investing since the funds don’t use the same active management techniques as other funds.Passive investing has two big advantages over active investing.First, a passive stock market mutual fund is much cheaper to run than an active fund because you can eliminate all the analysts’ salaries.In cutting costs this way, the savings can be passed along to investors in the form of higher returns.The second main advantage of stock index funds is that they perform better than actively managed funds. Some investors find it incredible when they learn that most mutual funds are flops, at least when it comes to generating returns for their shareholders. In 1998, for instance, 85 percent of all mutual funds that were set up to beat the S&P 500 failed to meet that goal. That is eight out of ten mutual funds that didn’t beat the market!The same holds true then that by investing in a stock index fund you are guaranteeing that you’ll never outperform the overall market, but less than 20 percent of all professional mutual fund managers master that task in any given year anyway. However, even knowing this, there are many investors that are convinced that they can pick out one of the funds that will be in the rare 20 percent club.This is easy in theory but actually much harder in practice. As you look at lists of the top-performing mutual funds for the last several years, you won’t likely find many of the same names on more than a few of them. It’s not uncommon for a fund to have a great year, but it’s very uncommon for a fund to consistently turn in above average performance.
In summary, the there has been an fast growing trend in recent decades to create passively managed mutual funds that are based on market indices known as index funds.These index funds are based on stock indices that are a fairly safe representation of the market at any given time. Many investors find that by investing in passive funds they are able to bypass the painful losses so often associated with active investing.