An index fund is an investment that holds a broad slice of the market, often hundreds or thousands of companies at once, rather than trying to pick individual winners. It's widely considered the best investment for most people, because it's simple, cheap, diversified, and it quietly beats the majority of professional investors over time.

The basic idea

Instead of buying individual stocks and hoping you picked well, an index fund buys a little bit of everything in a given market index, for example, a fund tracking a broad U.S. stock index owns tiny pieces of hundreds of the largest American companies. When you buy one share of the fund, you own a fraction of all those companies at once.

This means your returns match the overall market's returns, minus a very small fee. You're not betting on any single company. You're betting on the long-term growth of the whole economy.

Why index funds work so well

Three features make index funds powerful:

  • Diversification. By owning hundreds or thousands of companies, you're protected from any single one failing. If one company collapses, it barely dents a broad fund. Picking individual stocks concentrates risk; index funds spread it.
  • Low cost. Because an index fund just tracks an index rather than paying analysts to pick stocks, its fees are tiny, often a small fraction of a percent. Over decades, low fees make an enormous difference, because every dollar in fees is a dollar not compounding.
  • They beat most professionals. This is the surprising part: over long periods, low-cost index funds outperform the majority of actively managed funds and professional stock-pickers, especially after fees. When Warren Buffett bet that an index fund would beat elite hedge funds over ten years, he won easily.

Why "buying the haystack" beats finding the needle

The investing legend behind index funds put it memorably: don't look for the needle in the haystack, just buy the haystack. Instead of trying to find the few winning stocks (which is far harder than it looks, even for professionals), you own the entire market and capture its overall growth. You don't need to be right about any single company. You just need the economy, over time, to grow, which it historically has.

How to use them

  • Choose broad, low-cost index funds, ones tracking wide indexes with minimal fees.
  • Invest regularly and automatically, steady contributions over time.
  • Hold for the long term, index investing rewards patience, not tinkering.
  • Leave it alone, resist the urge to jump in and out based on market moves.

Why the research supports them

The millionaires in the major studies overwhelmingly credited steady, long-term investing, mostly through ordinary funds, rather than picking individual stocks. The boring, diversified approach wasn't a compromise for them. It was the path.

The honest limit

Index funds aren't risk-free. They rise and fall with the market, and can lose value significantly over short periods or even a bad decade. Owning the whole market protects you from picking the wrong stock; it doesn't protect you from a market-wide downturn. What index funds offer isn't a guarantee of gains. It's broad diversification, low cost, and the long-run growth of the economy, which for most people is the best honest bet available.

Sources

  • Warren Buffett's $1M bet vs. Protégé Partners (arranged 2007; ran 2008-2017). The S&P 500 index fund returned ~7.1%/yr vs. ~2.2%/yr for the hedge funds.

The Selfmade Newsletter: one idea every Friday on what self-made people do differently. Free, on Substack. Join here.

This article is for education only and isn't financial advice. Returns are never guaranteed.