Do you watch the daily ups and downs of the major stock market averages? These days, it's almost impossible not to. Well, with an index fund, your savings go right along for the ride.

But just what are index funds?

Businessman checking stock market on tablet
baranq / Shutterstock
When you invest in an index fund, it's like investing directly in one of the major stock market averages.

An index funds is a collection of individual stocks mimicking a familiar stock index.

The best-known index funds contain stocks in the S&P 500 index or the Dow Jones industrial average and try to mirror how those big-name indexes perform.

Other index funds follow the Wilshire 5000 (an index of all U.S. stocks traded domestically), the Bloomberg Barclays U.S. Aggregate Bond Index (a major measure of the bond market) or the Russell 2000 (which tracks smaller companies).

How did we get index funds?

Index funds were the brainchild of University of Chicago graduate students Paul Feldstein and Edward Renshaw, who in 1960 proposed the idea of an "unmanaged investment company."

They said investment advisers rarely got better returns for their clients than the major stock averages, so investors might as well have a portfolio that automatically buys every stock in the Dow industrials or some other index.

It took more than 10 years before the Qualidex Fund was launched, giving pensions a collection of Dow stocks. Then, in 1976, Vanguard Group offered an S&P 500 fund that's regarded as the first index fund for individual investors.

Should I invest in index funds?

Retired couple walking around the town with a map. Smiling mature man and woman roaming around the city.
Jacob Lund / Shutterstock
Index funds might make you more money than a professional stock-picker.

It's estimated that index funds currently hold about one-fifth of all the money currently invested in the U.S. stock market.

Why? Mainly the reason Feldstein and Renshaw noticed almost 60 years ago: Index funds often do better than fancy portfolios managed by professional stock-pickers.

The legendary — and incredibly rich — investor Warren Buffett made a bet in early 2008 that an S&P 500 index fund would beat a basket of actively managed hedge funds over 10 years.

By the end of 2017, it was clear Buffett had won the bet.

Index funds also tend to be cheap, because they're so simple. Standard mutual funds have much higher fees because they contain stocks hand-picked by managers who rely on research analysts. And those people need to be paid.

How do you buy index funds?

Eager to put some money into index funds? If you have an opportunity to open a 401(k) or other retirement plan where you work, do it — and make index funds the centerpiece of your portfolio.

Or, you can buy into mutual funds through any mutual fund company. Large fund firms may emphasize their own funds, so you might find a wider selection of index funds by turning to a smaller discount broker.

A discount broker also may provide more in the way of stock research and tools, if you're interested in those things. But if all you want is to focus on the funds, a large fund family may be the way to go.

Happy investing!

About the Author

Doug Whiteman

Doug Whiteman

Editor-in-Chief

Doug Whiteman is the editor-in-chief of MoneyWise. He has been quoted by The Wall Street Journal, USA Today and CNBC.com and has been interviewed on Fox Business, CBS Radio and the syndicated TV show "First Business."

You May Also Like

The 6 Factors That Decide Your Health Insurance Costs (and 3 That Don't)

Here are the facts about your premiums as well as a few common myths.

Low Mortgage Rates Help Shatter Home Sales Records

Home sales reached highs not seen since 2006.

How Does Debt Relief Work?

These options come with costs and risks but could still be the best way to debt freedom.

Why an 84-Month Auto Loan is a Clunker for Your Finances

Do you really want to be stuck making car payments for seven years?