How index investing works

Index investing is a little like filling a box with assorted chocolates. Instead of choosing only one kind, you take a selection that represents the whole display.

An index fund does something similar with investments. It holds shares of many companies instead of trying to choose the few that will perform best.

The goal is not to beat the market. It is to follow a market index as closely as possible. That is where the name comes from.

An index measures the performance of a group of investments. A Canadian stock index, for example, follows companies listed in Canada. An index fund holds those companies according to the index rules.

In a market-cap-weighted index, larger companies receive more weight. If a company represents 5% of the market, it will represent about 5% of the index portfolio. The larger the company becomes, the more of it the fund holds.

Imagine that the chocolate display represents the market. If 20% of the chocolates on the counter are caramel, a market-weighted box would also be 20% caramel. The box reflects what is available on the counter rather than someone's prediction about which kind will be most popular tomorrow.

Buying shares in every company yourself would be expensive and tedious. An index mutual fund or exchange-traded fund (ETF) does the work for you. By buying one fund, you can own a portfolio representing a broad part of the market.

The fund will not match the index perfectly because it has expenses and trading costs. But index funds are generally attractive for the same reasons the approach is simple: broad diversification, low costs, and no need to identify the next winning company.

The guide to active versus index investing explains how this differs from paying a manager to choose investments.