Index Funds vs. Mutual Funds

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Most beginning investors have heard this common advice: just buy an index fund. It’s not necessarily bad advice, especially for beginning investors who don’t feel confident assembling a portfolio.

If you’re looking at the investment options in a 401(k) or IRA, though, you’ll see many funds, and you’ll have to make decisions, including index funds vs mutual funds. Let’s start with the basics.

What Is a Fund?

An investment fund is a pool of investors’ money that money managers use to buy large quantities of stocks. This gives the “little guy” a chance to participate in a broad range of stocks.

For example, a fund might buy hundreds of different stocks. When you put money in that fund, you own shares in all those companies. You’d never be able to get that kind of diversification buying individual stocks!

Let’s look at the “index funds vs mutual funds” question, and see how these fund types stack up.

What Is an Index Fund?

An index measures the average price movement in a sector of the market. There are indexes for broad categories of stocks, like the S&P 500, the Dow Jones Industrial Average, or the NASDAQ. There are also more focused indices targeting oil stocks, technology, financial services, health care, etc.

Here is a chart of the S&P 500 as an example.

This index shows the average prices of S&P 500 stocks.

An S&P 500 index fund owns all 500 stocks of the index, according to the weightings of the index. If you invest in the fund, you technically own all stocks in the fund. The average investor couldn’t afford to buy shares of 500 companies.

The idea is to protect yourself through diversification. If you invest in one stock and that stock goes down in value, your investment loses value. If you invest in a fund you hold many stocks, which makes your investment less likely to decline dramatically in value.

Of course, an index itself can decline if the market overall is under stress. Over time, though, markets have always bounced back and risen, while individual stocks sometimes don’t.

How an Index Fund Works

An index fund is passively managed, meaning managers don’t make a lot of buying and selling decisions because they are limited to the stocks in an index. But it’s not quite that simple. Larger companies carry more “weight” than stocks of smaller companies. A big company will move the underlying index more than a smaller company would. So the manager buys more stocks of heavily weighted companies in an attempt to keep up with the index. Still, there is minimal management activity. 

Advantages

Index funds have real advantages, especially for investors who don’t have the time or the expertise for investment research.

  • Management costs are usually low.
  • You benefit from doing as well as the index. 
  • You don’t have to pick stocks and evaluate companies.
  • You don’t suffer huge losses if one company stumbles or fails.
  • If a company in the fund pays dividends, you get your share of those dividends.
  • The index fund has lower expenses (which come out of your earnings) because the manager doesn’t have to do much.

While it may seem like you are missing out on the expertise of a mutual fund money manager, it turns out that 80% of those managers[1] are doing worse than the market. They make some bad decisions about what to invest in.

What Is a Mutual Fund?

A mutual fund also pools money from thousands of investors, but it may not be limited to an index. It might, for example, invest in oil stocks it selects, financial stocks, or technology. So far, it sounds just like an index fund. But a mutual fund can choose individual stocks in a sector. It is not obligated to invest in every stock in a sector

Most mutual funds are actively managed: the money managers make constant decisions about which companies they expect to perform well. 

In short, a money manager picks stocks based on the prospect that they will rise in value. If you buy an oil stock mutual fund, you may own just a few oil companies instead of all oil companies.

A mutual fund can go down in value when most or all of its stocks have decreased in price. This happens when a sector goes out of favor with investors or when the entire market is in a downward trend. 

How a Mutual Fund Works

A mutual fund tries to do better than the overall market. Usually, a mutual fund has a sector it concentrates on. For example, you could focus on foreign stocks. The fund wouldn’t buy every foreign stock; it would choose among the best. This is a way to get some exposure in areas where you don’t know the companies very well. In our example, you may want some foreign stocks in your portfolio, so you could rely on a mutual fund money manager to choose the best ones.,

Advantages

Mutual funds also have advantages.

  • You might beat the market.
  • You have a money manager to make decisions. 
  • You don’t have to pick stocks and evaluate companies.
  • You don’t suffer huge losses if one company stumbles or fails.
  • If a company in the fund pays dividends, you get your share of those dividends.

A mutual fund has larger expenses because it pays a money manager to review companies and make decisions about buying or selling individual stocks. 

How to Choose

You choose between an index fund and a mutual fund based on your goals. You can try to match the market or beat the market.

You also can choose based on your investment style. Look at your lifestyle, the amount of time you have to invest, and how much you are willing to do research. 

Buy and Hold Lifestyle

With this approach, you put your money in an investment and let it run. You are looking at years as your timeframe for the investment. 

You don’t check the market every day, and you don’t make buy and sell decisions weekly or monthly.

This approach lends itself to mutual funds. Though you can hold an index fund indefinitely, some investors prefer to get in and out of an index fund when the markets go up and buy when the market is down.

Your initial research to evaluate the mutual fund may be all the study time you have to dedicate. 

Short-Term Trading Lifestyle

You use this approach if you like to watch the market daily or weekly. This may mean index funds are for you. You watch the news, study the markets, and try to avoid short-term losses.

If you decide to trade index funds this way, be prepared to study and learn about the markets and sectors. A good trader dedicates a significant portion of time to learning each week. You will want to watch whether the overall market is trending upward or downward.

Managing Risk

All investments involve risk, and all investors have to manage risk. Here are some basic risk management strategies.

Diversify

Any investment can lose value. An index can drop, and a whole sector can stumble. Consider putting your money in a few mutual funds or index funds. You can even invest in both mutual funds and index funds at the same time. This would be advantageous if you want to trade long-term in some funds and short-term in others. You can also find bond funds if you want some exposure in that area. There are also funds for gold, real estate, and other non-stock assets. 

Know What Your Fund Buys

Make sure you understand what you are buying because some funds overlap in their holdings. Avoid this because you will have double exposure. You can easily check the assets of either type of fund. Many financial sites list the holdings for funds. You can take a deeper dive on the Securities and Exchange Commission website.

How About an Index Mutual Fund?

There is such a thing as an index mutual fund. Don’t let the name confuse you. Think of an index mutual fund as simply an index fund. It will buy the stocks that are in the index it follows, and it has lower expenses because it doesn’t need active management from a money manager. 

That means that some mutual funds are index funds.

📚 For more information on the types of funds available, read up on the differences between mutual funds and exchange-traded funds or ETFs.



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