In Warren Buffett's 2016 letter to Berkshire Hathaway shareholders he wrote, "If a statue is ever erected to honor the person who has done the most for American investors, the handsdown choice should be Jack Bogle."

Jack Bogle is the founder of the Vanguard Company and created the first index fund in 1976. He set out to create a way to invest passively instead of relying on mutual fund managers making buy and sell decisions in an effort to outperform the market. His research found there's no way for a mutual fund to consistently outperform the market long term, but they can consistently underperform the market due to excessive costs such as management fees and taxes. Index funds simply aim to match the market returns as closely as possible.  

Bogle was influenced by the Nobel Prize winning economist Paul Samuelson, who would later claim that Bogle's invention ranks among "the wheel, the alphabet, Gutenberg printing, and wine and cheese."

The power of the index fund is that it enables a typical middle-class investor to invest very inexpensively while achieving excellent results, especially when compared to actively managed mutual funds. In fact, Buffett famously made a bet that simply holding an S&P 500 index could could outperform any active fund manager over a 10-year period -- and he won.

If all of that sounded like gobbledygook to you, read on. These are among the things this article will examine:

  • What an index is
  • How an index fund works
  • The advantages of investing in index funds
  • The disadvantages of investing in index funds
  • The difference between an index fund and an ETF
  • How to buy your first index fund

What's an index?

An index is a list of stocks or bonds that is assembled based on some set of rules. For example, the Standard & Poor's 500 (S&P 500) is a list of the top 500 stocks traded on the New York Stock Exchange and Nasdaq by market capitalization -- the total dollar market value of a company's outstanding shares. Certain rules exclude certain stocks that would otherwise qualify by market cap. For example, the companies must be based in the United States and they must be a corporation issuing common stock (no partnerships). 

Another popular index is the Dow Jones Industrial Average, a collection of 30 stocks that the editors of the Wall Street Journal decide offer a strong representation of the U.S. economy. There are similar indexes for other countries and regions as well.

A bull and a bear figurine on top of paper stock charts.

Image source: Getty Images

There are indexes that track just about everything. There are those that include equities based on market capitalization (large, mid-cap, or small), sector (e.g. biotech, real estate), region (e.g. Europe, emerging-markets), stock exchange (e.g. Nasdaq, Nikkei), and even indexes that attempt to track the entire global stock market.

Looking at the aggregated performance of the stocks or bonds listed on any of these indexes can provide investors with an idea of how "the market" is doing. American financial news will almost always focus on the performance of the S&P 500 index, the Dow Jones Industrial Average, and the Nasdaq-100 index.

How do index funds work?

An index fund works a lot like a typical mutual fund.

But instead of a mutual fund manager actively managing positions in the fund, an index fund outsources that decision-making process to the people in charge of developing the index. This can save investors a lot of money because there's no need to pay a mutual fund manager to make those decisions.

Even so, index funds still have a portfolio manager. Their job is to get results as close to the index as possible. The best way to do that is to buy and sell assets as they join or leave the index list. The hardest part is doing so in a way that minimizes taxable capital gains, which are the gains made from buying and selling a stock position. 

As such, index funds typically have a much lower expense ratio -- the percentage of assets paid to the mutual fund company -- than typical mutual funds. For example, Vanguard's Total Stock Market Index Fund Admiral Shares (NASDAQMUTFUND:VTSAX) have an expense ratio of just 0.04%. Schwab's Total Stock Market Index (NASDAQMUTFUND:SWTSX) has an expense ratio of 0.03%. Conversely, actively managed funds have an average expense ratio of 0.69%.

Removing the psychology of investing

Index funds save the time and effort of having to research investments and manage a portfolio yourself. But one of the other key advantages of investing in index funds is that they can also help you get better returns by removing the psychological biases that individual investors must overcome to manage a portfolio effectively.

In the 30 years from 1985 to 2015, the average equity investor achieved an average annual return of just 3.66%. By comparison, the S&P 500 returned 10.35% per year on average.

What explains the huge gap between individual investors and the S&P 500 index? Psychology.

Individuals suffer from psychological biases such as:

  • Loss aversion: The fear of losing money causes investors to sell at sub-optimal times and invest in lower risk equities, which end up producing lower returns.
  • Narrow framing: Making investment decisions without considering the context of a total portfolio.
  • Mental accounting: Taking undue risk in one area while avoiding rational risk in another due to mentally separating money into different buckets.
  • Anchoring: Focusing on the past instead of adapting to a changing market.
  • Unrealized lack of diversification: Thinking a portfolio is diversified despite investing in highly correlated assets.
  • Irrational optimism: Believing good things will happen to you and bad things will happen to others.
  • Herding: Copying the behavior of others, which usually results in buying high and selling low.
  • Regret: Letting previous errors get in the way of making new decisions.

Buying an index fund, or building a portfolio of index funds, can help mitigate the psychological hurdles individual investors face. An index fund is much easier to buy and hold, as an investor understands that it will practically match the index's return. That can help control loss aversion and a bunch of other biases that pop up when trying to construct and organize a portfolio of individual assets or actively managed mutual funds.

Index funds are tax efficient

Index funds can have much lower taxes than traditional mutual funds.  Many index funds have very low turnover in the stocks held. Unlike actively managed funds, there's not a lot of buying and selling.

That's not to say there's no buying and selling. Portfolio managers still have to invest new funds as they come in to an index, but that gives the fund hundreds of different price points to choose from if and when it needs to sell some stocks, enabling it to minimize capital gains taxes.  

The only time a fund will incur capital gains, which result from buying and selling a stock position, is when it has to sell its entire position in a stock because the index it is tracking changes. Even then, the portfolio manager may be able to offset those gains with losses in the position its selling or elsewhere in the portfolio.

By comparison, actively managed mutual funds are buying and selling positions all the time. Some of the gains will be taxed as short-term capital gains and some will be long-term gains. This makes tax planning incredibly difficult because an investor isn't able to exercise complete control over their capital gains.

The cheapest way to invest

Index funds are very inexpensive. Not only can you often buy an index fund without paying a commission, but they have very low expense ratios and don't generate much capital gains. That means taxes and fees won't eat into your portfolio. 

Expense ratios are the percentage of your holdings that go to the fund company and pay for the portfolio manager. Index funds can have an expense ratio as low as 0.03%. That means for every $10,000 you invest in that fund, you'll pay just $3 in fees. The average expense ratio for actively managed funds is 0.69%, so you would pay $69 per $10,000 invested. That can add up quickly in a large portfolio, and can significantly eat into your returns.

That stark difference can be especially important to consider when deciding whether to hire a financial advisor, who might put your money in a bunch of actively managed mutual funds. Not only will you have to pay the higher expense ratio for actively managed funds, but your taxes will be higher, and you will still have to pay the financial advisor, who could take a percentage of assets under management. That's not to say hiring a financial advisor is always a bad decision, but index funds provide a simple path to do just fine without one.

Index funds can help you keep more of your money for yourself, and incur fewer of what Buffett calls "frictional costs" incurred from buying and selling all the time.  In Buffett's 2005 letter to Berkshire shareholders he explained the concept by telling the story of the Gotrocks, a family that hypothetically owns every American corporation. The individual members of the Gotrocks family eventually hire "helpers" (brokers, managers, planners, etc.) to grow their wealth faster than their other family members, and in exchange the helpers get a fee. But as more and more Gotrocks family members hire more and more helpers, the Gotrocks family wealth is quickly transferred to the pockets of the helpers, and they're left with nothing. The Hadrocks, Buffett calls them.

One hand giving lots of money to another.

Image source: Getty Images

What's the difference between index funds and ETFs?

When you go to buy an index fund, you may come across something called an ETF, or exchange-traded fund. An ETF is merely a subset of index funds that trade more like equities than like mutual funds.

Mutual funds settle at the end-of-day price. You can buy any dollar amount of a mutual fund (subject to minimum investment amounts), which could result in fractional shares. You usually don't have to pay a commission to buy a mutual fund, and they are sold directly by a mutual fund company such as Vanguard. Mutual funds can also automatically reinvest dividends into the mutual fund.

An exchange-traded fund, as its name implies, is traded on an exchange with a constantly fluctuating price. Investors can buy shares just like a stock, which means no fractional shares, but an individual can buy as few as one share. It also means investors will likely have to pay a commission to buy and sell shares, but many brokerages offer a set of commission-free ETFs.

ETFs often have lower expense ratios than their index mutual fund counterparts. For example, the Vanguard Total Stock Market ETF (NYSEMKT:VTI) has an expense ratio of just 0.04%. The Vanguard Total Stock Market Index Fund Investor Shares mutual fund has an expense ratio of 0.14%, 10 basis points higher. The Admiral Shares of the same fund (which require a minimum $10,000 investment) have the same expense ratio as the ETF.

Given that ETFs are traded like stocks, liquidating an ETF is often easier and more tax efficient than in mutual funds. When an investor sells their ETF shares, they're selling to another buyer on the market. When a mutual fund shareholder sells his shares, the portfolio manager may need to raise cash to pay out the investor, potentially resulting in capital gains. Since index funds are becoming increasingly popular, portfolio managers have been able to pay out cash from the new cash coming in, but that might not always be the case.

Why you might not want to invest in index funds

There are a few limitations to index funds you should know about before developing an investment plan entirely around them.

The biggest one is that you're relinquishing control over your holdings. Your investments in an index fund are made at the whims of the index rule makers. So, even if you dislike a company and don't want to own its stock, you'll have to if it's part of the index you otherwise like. Likewise, you might find an index is perfect except it's missing a company or two that you'd really like to own. For example, Snap is excluded from the S&P 500 because its public shares don't have voting rights. You can always buy Snap shares separately, but you could incur high fees and have a tough time balancing your position.

Investing in index funds also removes your ability to react to the market. As discussed above, that can be an advantage for many investors who face serious psychological biases when it comes to buying and selling assets. But if you see an opportunity presenting itself in the market or you feel a company has become overvalued, you can't easily make an investing decision based on that information if you're committed to index funds.

Someone who enjoys researching individual equities may want to manage their own portfolio of just a handful of stocks. You don't need 500 different stocks to have a diversified portfolio, you can easily accomplish that with just 15 to 30 individual companies.

For someone who is not interested in all that stuff and just wants to grow their money, index funds provide a great solution.

Where to buy your first index fund

Bogle might've invented the index fund at Vanguard, but there are now many companies offering index mutual funds and ETFs to investors.

  • Vanguard: Vanguard is the largest provider of index mutual funds in the world. That makes sense considering it's been at it longer than anyone else. Its size enables it to charge very competitive fees and branch out into sector-specific indexes like Vanguard Health Care while providing a standard S&P 500 index fund as well. Minimum investments start at $3,000, but investors can start with less by committing to invest at least $100 per month.
  • Fidelity: Although Fidelity specializes in actively managed mutual funds, it also provides a good selection of index funds with competitive expense ratios. Fidelity requires a minimum investment of $2,500 or an ongoing investment of at least $100 per month.
  • Charles Schwab: Schwab offers some of the least expensive index funds available. The Schwab Total Stock Market Index Fund (NASDAQMUTFUND:SWTSX) has an expense ratio of just 0.03%. In other words, you'll pay just $3 per year for every $10,000 invested in the fund. You can also get started with just $1 and there are no ongoing investment requirements. 

If you want to take advantage of the commission free aspect of index-fund investing, you'll have to set up a brokerage account at the respective mutual fund company. Alternatively, all three companies listed above offer ETF versions of some of their index funds, which can be bought in any brokerage account for a standard commission (and are sometimes commission free depending on the broker).

You can also buy index ETFs from the following companies.

  • Blackrock iShares: Blackrock's iShares is the largest issuer of ETFs in the world. It has funds for just about any index you can think of, offering 800 different ETFs. Investors hold over $1 trillion in iShares.
  • Invesco Powershares: Invesco's Powershares are also very popular. It has over 120 ETFs available, including the popular Powershares QQQ (NASDAQ:QQQ), which tracks the Nasdaq-100 index.
  • SPDR: Pronounced like "spider," SPDR is the second-largest ETF provider behind iShares. It's owned by Standard & Poor's, the same guys in charge of determining the S&P 500 rules. So, it's safe to say the company knows a thing or two about indexes.

All of the above provide great investment options for index fund investors. The key to investing in index funds, however, is to understand the index your investing in.

Most investors that don't want to do a lot of research would do well with a standard total stock market index fund like Schwab Total Stock Market Index Fund or Vanguard's Total Stock Market Index Fund Admiral Shares.

Depending on your risk profile, you might want to pair it with a global bond index fund or an international markets index fund (or both). You could also explore options like a REIT index fund or a gold index fund. Younger investors should be willing to take on more risk with a higher percentage of equities versus bonds.

Investing in index funds is one of the simplest ways to grow your wealth over time. For someone that's not interested in researching individual companies to put together a balanced and diversified portfolio themselves or for those that are simply afraid they'll fall prey to the psychological biases that prevent individual investors from doing well in the market, index funds are the best investment tool available.

Adam Levy owns shares of BlackRock. The Motley Fool owns shares of and recommends Berkshire Hathaway (B shares). The Motley Fool has a disclosure policy.