Like the weather, the stock market is always changing and hard to predict. Nobody gets it right all the time.

That's one reason why index funds are popular. They mitigate some of the risk that you'll get drenched when the market turns bad. An index fund buys shares in companies comprising a particular benchmark known as an index.

The S&P 500 index, for example, is a group of 500 stocks, weighted toward larger U.S. companies, that strives to mimic that benchmark's performance. If the S&P 500 gains 8% in a particular year, you would expect an S&P 500 index fund to provide a simi­lar return. Such funds are considered to be "passively managed" because, generally speaking, the fund manager doesn't actively pick stocks based on market conditions and research.

For the average investor, index funds often make sense. By allowing you to diversify holdings, they mitigate risk. Say you have $25,000 to invest. To spread that investment over several companies and sectors of the economy, you would have to buy at least 15 to 20 stocks in small amounts. Moving money from one stock to another, you'd pay a commission, which would reduce your investment return. Investing the same amount of money in a passively managed index fund would allow you to spread your investment over many more companies at a lower cost. Even if several companies in the index failed, you wouldn't lose your entire investment.

In general, investing in index funds requires less time, skill, and knowledge than investing in individual stocks. Some people love to research companies and spend their free time tracking the market. Because they're willing to accept more risk, they may gain greater returns than index fund investors. Many folks, however, just want someone to invest their money for the long term and have little interest in the day-to-day vagaries of the market. That's why many employers offer index funds as a core investment option in their 401(k) plans.

Ultimately, investing is a matter of individual preference. It depends on your tolerance for risk, time horizon (how long until you need the cash), skill, and knowledge.

© MC 2013