What Is an Index Fund?
An index fund holds every company in a chosen index in proportion to their size, so its return tracks the index minus its fee. Because nobody is picking the holdings, the fee is small, and over decades that fee difference decides more of the outcome than anything else you can choose.
The whole idea is that nobody is choosing. That sounds like a weakness and it is the reason the fee is small, which over thirty years is the thing that decides the outcome.
How it works
An index is a list of companies and a rule for weighting them — usually by size, so the largest members move it most. The stock market page covers what an index is.
An index fund buys that list. No analyst decides what to hold, because the list already decided.
So the fund’s return is the index’s return, minus its fee. That is the entire mechanism, and it is why the fee gets the attention on this page rather than the strategy.
The fee is the whole decision
Take $10,000, a 7% gross annual return, and thirty years. Change only the fee:
| Annual fee | Ending value | Lost to the fee |
|---|---|---|
| 0.03% (index fund) | $75,485 | $638 |
| 0.20% | $71,968 | $4,155 |
| 0.75% (typical active fund) | $61,641 | $14,482 |
| 1.50% (adviser plus fund) | $49,840 | $26,283 |
The 7% is an assumption and it is stated. The rest is compound arithmetic — you can check every row of it.
Between the first row and the third is $13,844 — 18% of the ending pot. Nothing about the investment changed. The same companies, the same returns, the same thirty years.
This is why index funds exist, and it is the one number on this page you control completely.
Time does the work
Same $10,000, same 7%, different lengths of time:
Ten years: $19,672. Twenty: $38,697. Thirty: $76,123. Forty: $149,745.
Notice that the last decade adds more than the first three combined. That is what compounding means in practice, and it is why “when did you start” beats almost every other decision available.
It also means the cost of waiting is not linear. A year of hesitation early is expensive in a way a year of hesitation late is not.
You own the average
A single company can go to zero. An index cannot, because it is hundreds of them and the failures are replaced.
That is the actual protection on offer, and it is worth being precise about what it is not. It does not stop the whole index falling; it stops one bad holding ending the position.
The cost of that protection is the ceiling. You will never beat the average, because you are buying it. Anyone selling you a fund that might beat it is selling you the fee in the table above.
The fall you will sit through
On the illustrative history above, the index falls 32% from its peak and takes 59 bars to get back to the old high.
Nothing is wrong in that picture. No holding failed, no fee changed, and the ending value is higher than the starting one. It simply took a long time and felt awful in the middle.
Every long-horizon plan is really a plan for this stretch, which is why the number belongs on the page before you buy rather than after.
A worked example
Check the fee first. It is published as the expense ratio, and it is the only figure on the factsheet you can rely on.
Multiply your intended holding period by that fee. Thirty years at 0.75% is roughly 18% of the pot on the arithmetic above.
Then decide the amount and the schedule, not the timing. A fixed amount on a fixed date removes the decision that most often goes wrong.
And write down the fall you will hold through. If 32% would make you sell, the position is too large before you have bought it.
The original data
Across our study of 24,971 trading videos, 138 cover index funds. The median one gets 66,065 views — among the highest medians measured anywhere in this glossary — and only 46% fail to pass 50,000, one of the lowest saturation figures in the study.
The corpus carries no description text at all for any of the 138, so this page makes no claim about how the topic is written.
The contrast with the trading side is the finding. 138 videos on index funds at a 66,065 median, against 698 on moving average convergence divergence (MACD) at 2,130 and 1,639 on forex at 8,397. Five times fewer videos, thirty times the audience per video.
When it fails
You paid for the wrong version of the same index
Two funds tracking the identical index at 0.03% and 0.75% hold the same companies. The table above is what the second one costs, and nothing in the holdings justifies it.
You sold during the 32%
The recovery in the chart happens to people who were still holding. Selling at the trough converts a temporary fall into a permanent one, which is the only way an index fund reliably loses money.
The index was not what you thought
“Index” does not mean broad. A single-sector or single-country index concentrates rather than diversifies, and it carries the same fee argument with none of the protection.
It went nowhere for years
Flat decades exist. The compounding arithmetic above assumes a return that arrives smoothly, and it does not — which is an argument for a longer horizon rather than a different fund.
You judged it from where you are standing
Every recovery is obvious afterwards and none of them is obvious here. The schedule you set while calm is the only thing that decides what happens next.
Related
ETFs are the same idea in a wrapper that trades like a share.
How to start investing is the procedure once you know what you are buying.
And the stock market is what an index is an average of.
I trade and I also hold index funds, and I keep the two in completely separate accounts on purpose. The trading account is where I take views; the other one is where I do not, and mixing them was the fastest way I found to turn a long-term holding into a badly-timed trade.
— Michael Whitman
This page is educational, not financial advice. Test every idea on your own charts before risking money.