This article discusses three reasons that you should seriously consider investing in an index funds. However, before I can begin discussing those reasons, first, I need to answer this question: Just what are index funds?

What are index funds

Index funds are mutual funds or ETFs (i.e. exchange-traded funds) that are put together to mirror an index such as the S&P 500, the Nasdaq Composite Index, the Dow Jones Industrial Average, or any of a host of other indexes. If an index has stocks "A" through "Z"', the index fund that is set up to replicate it will have those same stocks in its fund basket as well. Not only that, it will have those stocks in the same proportion as they are in the underlying index itself. That's why it is said that an index funds mirrors the underlying index that it tracks simply because, in a real sense, it is a reflection of the actual fund. You might think of the index fund as a micro-index to the macro-index, the actual index itself.

Lower cost

Now that you have a clearer view of just what an index fund is, let's talk about two reasons you should consider investing in one. The first reason that you should consider investing in an index fund is that they are passively managed. In other words, there is no professional money manager actively picking stocks to add to or remove from the fund. Because of this, the expense rate of an index fund as opposed to a mutual fund is lower. In fact, it is said to be about 0.2% for the former and 1.5% for the latter. This in itself is a good reason to put your money into an index fund as opposed to a mutual fund-more of your money goes into your investment portfolio and less into the pocket of the broker who is managing the fund.

Diversification

A second reason to consider investing in an index fund is that you are not putting all of your eggs into one basket. That is to say that you are diversifying your investments by investing in an index fund. For example, if you were to buy an index fund that is set up to track the S&P 500, you would own a piece of not just one or two but 500 of the largest companies in America. The same holds true of other indexes such as the Wilshire 5000, which tracks over 6500 stocks on the American Stock Exchange or the Nasdaq Composite Index, which covers over 3000 stocks traded on the Nasdaq Stock Exchange.

Better performance

The third and final reason-and perhaps the most important reason-that you should consider investing in an index fund is that most index funds outperform most mutual funds. In fact, it is said that the number of passively managed index funds outperforming actively managed mutual funds, depending on the year, is anywhere from 50% to 80%. That raises the question of why should be wasting your hard-earned money on hiring a money manager to actively manage your money when most are underperforming the market itself? Or to put in it in more current terms, why pay a CEO millions of dollars when s/he is overseeing a sinking ship? It just doesn't make a lot of sense.

Conclusion

In summary, an index fund is mutual fund or ETF (exchange-traded fund) designed to replicate an index such as the Dow Jones Industrial Average (DJIA) or the S&P 500. It is important that you seriously invest in one for the following reasons: One reason is that their operating expense is less than that of a actively managed mutual fund. Another reason is that they add diversification to your portfolio. And last, they tend to outperform mutual funds.