Index funds have long been considered one of the smartest investments you can make. They're affordable and well diversified, and they tend to generate solid returns over time, outperforming actively managed funds from the top investment firms. In 2007, Warren Buffett made a $1 million bet that an S&P 500 index fund would beat the returns of an actively managed hedge fund over ten years -- and he won in a landslide. 

Buffett's victorious bet may be reason enough for some to start adding index funds to their portfolio, but if you need more convincing, read on to understand what index funds are and what makes them so popular.

How do index funds work?

Index funds are mutual funds -- bundles of other investments, like stocks and bonds -- that track the performance of a market index, like the S&P 500. These indexes are metrics that measure the value of a group of stocks over time. Each stock is weighted, usually based on its market value, so larger companies' stock prices affect the value of the index more than smaller companies' stocks.

Some indexes are tailored to specific sectors, geography, and stock exchanges. The funds that track these indexes contain the same investments in approximately the same proportion as the index itself. This way, when the index as whole performs well, the value of the fund increases alongside it, which boosts the balance of your portfolio.

Stock charts

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Benefits of index funds

There are three key benefits to investing in index funds: broad diversification, low costs, and solid returns. 

1. Broad diversification

The most obvious benefit of investing in index funds is that your portfolio becomes instantly diversified, minimizing the chances you'll lose your money. 

For instance: An index fund that tracks the S&P 500 has 500 different investments. The performance of these different stocks will vary and fluctuate over time, but when your money is spread out among so many assets, these ups and downs are smaller.

If you put all your money in a couple of stocks and they both drop in value, you could lose your initial investment. But when you have 500 different investments, a single stock that loses value won't decimate your portfolio, as 499 others are picking up the slack.

2. Low costs

An expense ratio is an annual fee that all mutual funds, including index funds, charge their shareholders, usually a percentage of the total assets you have invested. If you have $1,000 in a mutual fund with a 1% expense ratio, you pay $10 per year to own it.

Actively managed mutual funds often have expense ratios between 1% and 2% because portfolio managers are responsible for picking the investments in the mutual fund and actually doing the buying and selling. 

Index funds, on the other hand, are passively managed.  Due to their design of tracking an index, investments within the fund rarely change, so there's little work for portfolio managers to charge you for. Index funds pass these savings on to you in the form of lower expense ratios. Many charge somewhere between 0.05% and 0.07%, and some have expense ratios as low as 0.03%. If you invest $100,000 in a mutual fund with a 0.03% expense ratio, you will pay only $30 per year, versus the $1,000 you'd owe annually if you invested in a mutual fund with a 1% expense ratio. Not small potatoes.

Naturally, index funds have a lower turnover ratio than actively managed funds. Turnover ratios measure the percentage of a mutual fund's holdings that are replaced in a single year. For example, if the fund had 100 stocks and 10 were swapped out for new ones this year, the turnover ratio is 10%. If those assets are worth more when they're sold than when you bought them, the difference between the two prices is considered a capital gain and you'll pay taxes on this amount, costing you even more money. This isn't as much of a concern with index funds, though thanks to their low turnover, about 1% to 2% per year, compared with 20% or higher for some actively managed mutual funds.

3. Solid returns

As Buffett knew when he made his $1 million bet, even the smartest and most diligent portfolio managers can't make actively managed mutual funds beat index funds. Only 23.51% of actively managed mutual funds outperform the S&P 500 over five years, according to the latest date from Standard & Poor's, and other studies have supported this. Index funds have generally high returns and low costs, which make them an excellent value for investors trying to keep expenses low and profits high, which should be everyone.

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How to get started

You can purchase index funds through a brokerage firm or a mutual fund company. Look at the index funds offering and whether there are investment or account minimums. Some may require a minimum investment of several thousands of dollars and a recurring monthly investment after that. If you don't plan to invest a lot right away, you may be better off going with a company that doesn't have an account minimum.

Then, choose an index fund. The S&P 500 and the Dow Jones Industrial Average (DJIA) are two of the best-known indexes for U.S. stocks, and index funds that track them are good choices for beginning investors.

But there are many more options. Look at how the index fund you're interested in has performed historically. Don't be unnerved by temporary dips in value, but try to choose one that has pretty consistent growth over time. You should also check its expense ratio. Calculate how much it will cost you based on how much you plan to invest, and make sure you feel comfortable paying that amount.

Whether you're new to investing or not, an index fund is a great asset to add to your portfolio. It takes a little time to find the right index fund for you, but once you do, you can sit back and let your money grow.