- Another type of financial institution
is an investment fund.
Remember a key aspect of investing
is that we can reduce our risk through diversification.
Don't put all your eggs in one basket.
But that can be kind of tough.
Let's say I've got $3000 to invest.
It's kind of tough to take $3000
and split it up and invest a little bit here,
and a little bit there and spread it out
among 25 or 30 investments.
An investment fund company helps me
do this diversification for a fee.
So here's what happens with an investment fund.
First, you send them your money with instructions.
Here's how I want you to invest my money.
Then the investment fund invest the money on your behalf.
Of course you pay a fee to the investment fund.
They efficiently diversify your investment
given your instructions and they charge you
a little bit of a management fee.
It's a very efficient way to allow individual investors,
people like you and me to diversify our investments.
There are different types of investment funds, index funds,
manage funds, private equity funds and hedge funds.
We'll start with an index fund.
Think of an index fund as a computer.
I send in my $3000 to the index fund and I say,
I want you to invest this according to a mathematical rule.
An example of a popular index fund
mathematical rule is as follows,
pick the 500 largest companies in the United States
and just spread out my $3000 investment
among those 500 companies.
Don't think!
Don't try to pick which companies
you think are going to do well,
just invest based on that mathematical rule.
Index funds are very popular because
their management fees are very low.
Index investing is ideal for people
who just want to put their money in and let it sit there,
slowly growing over time.
The most popular type of index fund
is called the S&P 500 Index.
S&P stands for Standard & Poor's
which is just a name of a company.
500 represents the 500 largest companies
in the United States.
The S&P 500 Index is a common performance
benchmark for all investment funds.
If I'm managing an investment portfolio,
I want to, at least beat the S&P 500 Index.
Investors say the following,
how did the investment manager do
compared to the S&P 500 Index?
If that investment fund can't beat a strategy
of just randomly investing in the 500 largest companies
in the United States, maybe I should find another fund.
An investment in the S&P 500 Index
is not a risk-less investment.
For example, the value of the 500 companies in the index
went crazy around the year 2000.
Before the year 2000, the values went up substantially.
This was called the Internet Bubble.
Not long after the year 2000, the Internet Bubble burst
and the average value of the shares of the companies
in the S&P 500 dropped dramatically.
In a similar fashion, before 2008,
the S&P 500 Index climbed again
in association with the housing bubble in the United States.
When that bubble burst in 2008 and 2009,
the S&P 500 Index plummeted again.
So, an S&P 500 Index investment involves risk
but for investors who are long-term investors,
the S&P 500 Index can be a very prudent investment,
over the long-term.