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Ask Dave

What Are Index Funds?

Michael asks Dave to explain index funds versus mutual funds.

QUESTION: Michael on Twitter asks Dave to explain index funds versus mutual funds.

ANSWER: Index funds are a type of mutual fund.

A mutual fund is simply where people mutually fund to a common investment goal.

You can have a bond fund and people mutually put money in, and then that fund buys lots of bonds versus putting all your money in one bond and taking more risk. You can have a growth stock mutual fund where people mutually put their money together and they buy stocks in companies that are growing known as growth stocks. You can have an aggressive growth stock mutual fund, which consists of companies that are aggressively growing, usually younger companies or smaller companies or startup companies or high-risk sectors of the economy like tech and those kinds of things might be there, so you find the aggressive growth.

What the index fund is—it’s a mutual fund—everybody’s mutually funded it—and they’re buying the stocks of an index. There are several indexes that measure what the stock market’s doing. The most famous is the Dow Jones Industrial Average. That is an index. No one does a fund off of that that I know of—not one I would buy anyway.

The most famous in the mutual fund world would be the S&P 500, which is the 500 largest stocks on the New York Stock Exchange according to the company Standard & Poor (S&P). So it’s the biggest 500 companies, so as the stock market goes, so goes the S&P index. When you buy an S&P index fund, you’re basically going to follow the market. Whatever the stock market does—the New York Stock Exchange—that’s what your return’s going to be.