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Index Investing
Guarantees Average Performance

Index investing is the easiest way to earn an average return on your money into the market. The entire personal finance industry relies on index investing for retirement estimates. And most wealth managers and registered investment advisors use them to benchmark their performance.

That said, you can't invest directly in an index. For example, you can't "buy" a share of the S&P500. You can buy a share of a fund that represents the S&P500, like $SPY (SPDR S&P 500 ETF) or $VOO (Vanguard's S&P 500 ETF). Instead, an index fund is just a representation of an index.

Investments (such as mutual funds and ETFs) try to mimic the performance of the index; sometimes by buying all the different components of the index, sometimes not.

When you buy index funds, returns are based on the "average" price movement for all the tickers in that fund. If the funds replicate the pieces of the index properly, then the price movement of the fund should mimic the index on a long-term basis.

Advantages of Index Investing

• Low transaction costs
• Exposure to many investments within an asset class
• "Guaranteed" average performance**

Disadvantages of Index Investing

• Fees can be high
• Overexposure to a single investment or asset class (not diversified)
• "Guaranteed" average performance**

**Yes, it's both.

Types of Indexes

The two most common types of indexes are equal-weighted and market-capitalization weighted.

A market-capitalization-weight index (also called a value, market-cap or cap weighted index), means that a ticker's share of the index is based on it's market cap (stock price x the number of shares).

For example, the S&P500 ($SPX) is a cap-weighted index. This means that companies with big market capitalization (e.g. Apple or nVidia) influence the daily price movement of the $SPX more than small market capitalization companies.

An equal-weight index means that every ticker has an equal weighting or fixed percentage. If the fund had 10 stocks, then each one would account for 10% of the index.

Returning to the S&P500 example, Invesco offers an equal weight version ($RSP) that assigns the same weighting to every ticker in the fund (i.e. fixed percent of the total).

Segmentation

The invention of the ETF and online brokers was a boom for index investors, as companies continue to find new ways to segment the markets: asset classes, industry classification, derivatives, proprietary equations, leverage, you name it.

But all that customization comes with a price; sometimes in the form of higher fees, sometimes in the form of "hidden" tax consequences via partnerships (e.g. Sch. K-1's for commodity funds). So it pays to do your homework before just blindly buying a fund, just because you can.