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. A broad index of hundreds of companies has never done so, because the failures are replaced — though it can fall by half, as the S&P 500 did in 2007-09, and a narrow index of a few similar companies carries more of the single-company risk.
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
The S&P 500 fell 56.8% from its October 2007 peak to March 2009 and did not get back to the old high until March 2013.
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.
And it was not a one-off. Since 1950 the S&P 500 has fallen 20% or more from a record close eleven times, and three of those falls went past 45%: 1973-74, 2000-02 and 2007-09.
The quickest recovery, in 2020, was back at a record within six months; the 1973 fall took until 1980. The list of falls behind this chart is published.
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.
Read the cost off the table above rather than multiplying. Over thirty years, 0.75% instead of 0.03% costs about 18% of the ending pot. Multiplying 30 years by 0.75% gives 22.5%, which measures something different, so for your own fee and horizon use the fee drag calculator instead of a shortcut.
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 a fall of more than half — the S&P 500’s 56.8% from October 2007 to March 2009 — 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, 132 have “index fund” or “index funds” in the title. The median one gets 69,951 views — among the highest medians measured anywhere in this glossary — and only 44% 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 132, so this page makes no claim about how the topic is written.
The contrast with the trading side is the finding. 132 videos on index funds at a 69,951 median, against 471 with moving average convergence divergence (MACD) in the title at 3,645 and 1,313 with forex at 10,442. Up to ten times fewer videos, and up to nineteen 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 fall
The recovery 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
The question: Down 20% and your plan says keep buying. Do you?
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 choose an index fund is the next decision: which index, then which fund tracks it most cheaply and closely.
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.
An index account is the place where you do not act on views about the market. If you ever trade as well, keep it in a completely separate account; mixing the two is the fastest way to turn a long-term holding into a badly-timed trade, and the separation is what keeps that from happening.
— Michael Whitman
This page is educational, not financial advice. Test every idea on your own charts before risking money.