In short: An index fund holds the investments in a market index, such as the S&P 500, instead of trying to pick winners. That gives you wide diversification at a low cost. For beginners, one broad, low-fee fund held for many years is a simple way to own a share of the market’s growth and its falls.
What an index fund is
An index is a list of investments chosen by a set of rules. The S&P 500, for example, tracks about 500 large US companies. An index fund buys what is on the list and adjusts its holdings when the list changes, with no manager deciding which companies look promising. When you buy one share of the fund, you own a small slice of everything inside it.
The results follow from that design. You get roughly the market’s return, minus a small fee. You will never beat the index, and you will not fall far behind it either. For an investor who wants to own the market rather than outsmart it, that is the whole point.
Why costs matter so much
Fees come out of your return every year, whatever the market does, so small differences grow large over time. Take $100,000 left to grow for 30 years. These figures are our own illustration and assume a 7% return before costs, which is not a forecast or a promise.
| Annual fee | Value after 30 years |
|---|---|
| 0.05% | About $751,000 |
| 1.00% | About $574,000 |
That one percentage point costs about $177,000 in this example, because each dollar paid in fees also stops compounding. Broad index funds are often among the cheapest products available, which goes a long way toward explaining their results. Compound interest works against you on costs just as it works for you on returns.
Index funds against active funds
Active managers try to beat the market through research and selection, and they charge more for it. The record is difficult for them. S&P Dow Jones Indices’ mid-year 2026 scorecard found that 79% of actively managed US large-cap funds trailed the S&P 500 over the year to June 2026. Over five years, 89% did, and over fifteen years, 90%. Critics of these scorecards argue they understate active performance in some respects, and some funds do beat the market. What remains difficult is telling which ones will do so before the fact.
| Index fund | Active fund | |
|---|---|---|
| Goal | Match an index | Beat an index |
| Typical cost | Low | Higher |
| Manager’s judgment | Minimal | Central |
| Taxes in a taxable account | Often lower, because of less trading | Often higher |
| Main risk | Takes the full market fall | Market fall plus poor selection |
An index fund does not protect you from a market decline. When the market falls, your fund falls with it, and it has no manager who can step aside. That is the bargain you accept for low costs and broad exposure.
Mutual fund or ETF?
Both can track the same index, and the difference is mostly about how you buy them. Index mutual funds are bought at the price set at the end of each trading day and often allow automatic contributions in round dollar amounts. Exchange-traded funds trade throughout the day like shares and often have no minimum beyond the price of one share, or even a fraction of it.
For a long-term investor, the choice rarely matters much. Pick whichever your account handles most conveniently. ETFs can be somewhat more tax-efficient in taxable accounts in the US, and the ability to trade all day offers no benefit to someone who plans to hold for decades.
How to choose your first fund
Four checks cover most of the decision.
- What does it track? A total market or broad large-cap fund gives wide exposure. A narrow fund covering one sector or theme is a concentrated bet, even if it carries the word “index”.
- What does it cost? Compare expense ratios among funds tracking the same index, since those funds are close to interchangeable.
- How closely does it follow? Its returns should stay close to the index, minus the fee. A wide gap is a warning sign.
- Does it fit your account? Check for trading commissions, minimums and whether your 401(k) offers it.
Many beginners start with a total US market or S&P 500 fund and add an international fund for global diversification. Bonds can then be added to reduce swings, as covered in how to start investing. A target date index fund bundles all of this into one holding if you prefer not to decide. The SEC’s guide to diversification makes the broader case for holding different asset categories.
Common worries
Does everyone indexing distort the market? This is a live debate among academics. Active investors still set prices through their trades, and there is no agreement that passive investing has broken that mechanism, though it is worth following.
Isn’t the S&P 500 concentrated? It can be. The index is weighted by company size, so the largest firms have an outsized effect on returns. A total market or global fund spreads that risk somewhat further, though it will still reflect how the market is weighted.
What about falling markets? These funds can stay down for years, and the temptation to sell is the greatest risk most index investors face. Holding enough cash and having a written plan makes it much easier to stay invested, which is one of the lessons in our guide to personal finance basics and the psychology of money.
Frequently asked questions
Are index funds safe?
They are diversified, which is different from safe. A broad fund removes the risk that one company ruins you, but it remains fully exposed to the market as a whole, and that market can fall sharply. Treat them as long-term holdings and keep money you will need soon in savings instead.
How many index funds do I need?
Often one to three. A single target date fund is enough for many investors. A simple alternative is a US stock fund, an international stock fund and a bond fund. Holding many similar funds usually adds overlap rather than diversification, because they all tend to own the same large companies.
How do index funds pay me?
In two ways. Dividends from the companies are passed along to you, either in cash or reinvested automatically if you choose, and the value of your shares can rise as the underlying companies grow. Reinvesting dividends during your working years lets that income compound along with everything else.
Are thematic index funds a good place to start?
Generally not. A fund tracking artificial intelligence, clean energy or a similar theme follows a rules-based index, yet it holds a small slice of the market, usually at higher cost and often after the theme has already become popular. If you want one, keep it as a small addition to a broad core.
