An index fund is a financial instrument that provides exceptional diversity at low cost. It is traded like a stock, except when you buy a stock you purchase shares in one company. When you buy an index fund, you buy all the companies in the index it tracks, all at once, in one simple transaction. So instead of buying a company you buy the entire market, and your financial returns replicate closely those of the market the index tracks.
Index funds were invented by John Bogle, who wrote his senior thesis at Princeton in 1951 on them. Later Bogle started Vanguard, now one of the largest asset managers in the world, with indexing as its core philosophy.
Originally index funds were dubbed "Bogle's Folly" because the financial industry assumed the premise was absurd: that investors tracking an index could do better than those with professional, expensive mutual fund managers.
The financial industry turned out to be wrong. Decades of data now show that Bogle was correct, and by a long shot (1). In those decades, as data piled up in its favor, the idea of index investing moved from a fringe concept to the mainstream. Today more money is being invested in index funds than in active mutual funds.
"Beethoven could tell you how to write a symphony but you can't write a symphony like Beethoven does. You can't copy, with any hope of success, a Beethoven or a Warren Buffett. You can copy Bogle at any moment of time. Just buy index funds."John Bogle
Unlike most mutual funds, an index fund does not have a fund manager making active decisions about what to buy and sell each day. The job of the people running the index fund is to closely track it's underlying "basket" of securities - that is all. For example, all of the large companies in America. Or all of the publicly traded real estate investment trusts. Because of this, it is called a "passive" investment. Most mutual funds are considered "active" investments because fund managers are deciding what securities to buy and sell.
Despite the fact that they generally outperform actively managed funds, index funds often charge one-tenth to one-thirtieth the fees of active funds!
"You get what you don't pay for."Bogle, on protecting your savings from fees
Unlike Bogle's original fund, index funds don't just track the S&P 500 anymore. There are thousands of index funds, and they track every imaginable sector and country around the world. I will help you differentiate between them and simplify this universe to a handful of the most appropriate, diverse, and low-cost funds.
Index funds could be one of the most significant inventions of the 20 century for you. Simply buy entire markets at once, minimize your fees in doing so, and compound your results year in and year out. A conservative analysis shows that over a lifetime of work and saving you will transfer 66% of your money to the financial industry if you pay its standard high fees. Index funds free you from this.
(1) Source: Bogle Financial Markets Research Center.