Index funds are some of the most popular ways of investing these days, and for a good reason: They are, a low-cost, diversified, hands-off, and relatively easy way to get into the stock market.
When you buy an index fund, you ideally get an all-around selection of several stocks in a single package without the need to purchase each stock individually. And since these funds hold all of the investments in one index instead of paying a professional to do the stock-picking, management fees are very low. This means higher investment returns for individual investors.
What’s an Index fund?
To understand what an index fund is, it’s important to understand the concept of an index and a mutual fund. Simply put, an index is a measure of something. In finance, an index measures the performance of a group of bonds, stocks, or a market segment.
A mutual fund is an investment vehicle designed to pool money from multiple investors in order to buy a larger pool of diversified assets. Mutual funds are usually managed by a fund manager, and the individual investors are charged a management fee for the convenience of having the fund manager, and the diversification.
An index fund ideally combines both concepts. It’s essentially built upon the concept of a mutual fund, with the main difference being that the index fund matches a broader index rather than having a fund manager pick the stocks or bonds. This helps to keep the costs low and more money in the pocket of the investor.
An expert or a group of experts determine the elements that define the portfolio that they are assembling. When you invest in an index fund, you are investing in all the elements included in the index. Index funds typically seek to match the return of a particular index.
One of the most famous indices is the Dow Jones Industrial Average, commonly referred to as The Dow. It’s made up of 30 blue-chip stocks that are important to and therefore representative of the U.S. economy. The companies it tracks span all business sectors except utilities and transportation. The individual stocks are weighted based on the stock price and adjustments for things like stock splits.
The S&P (Standard and Poor’s) is perhaps the most widely used index around the world, and generally uses a more sophisticated method than the Dow to choose its components. Still, it’s another simple way for a new investor to get into the market.
Why Invest in Index Funds?
By matching the often impressive performance of the financial markets over time, index funds give investors an easy and effective way to build wealth in the long run, without the need to become a stock market expert.
Pros of Investing in Index Funds
Here are some of the reasons why index funds are attractive to investors:
- Relatively low risk: Most index funds are made up of dozens or hundreds of stocks and other instruments. This kind of diversification lowers the risk of big losses in case something bad happens to one or two companies in an index.
- No need to research individual stocks: You only need to find an index that is made up of the stocks you wish to invest in.
- Significantly less expensive: Index funds tend to be much less expensive than alternatives such as actively managed funds because you don’t need to pay a fund manager to come up with their own stock picks.
- Available for a broad range of investments: You can choose to buy stock or bond index funds, which generally make up two large parts of most investors’ strategies. You can also opt for index funds that are more focused on specific market segments.
- They make it easier to stick to your investing plan: Index funds allow you to invest your money automatically, say on a monthly basis. Plus, they help you ignore the short-term fluctuations with the confidence of getting a share of the long-term market growth.
- You pay fewer taxes: Index funds don’t have a lot to do with actively buying and selling instruments as actively managed funds do. This way, they avoid generating taxable capital gains.
Cons of Investing in Index Funds
- You’ll never be able to beat the market: This is because index funds are specifically designed to match the performance of the market.
- You won’t always be able to own all of the stocks you like: Based on the Index fund you choose, you may end up owning stocks that you’d rather not own, and missing out on others that you’d prefer.
- There’s no loss protection: Since index funds track the market in both good and bad times, your index fund will plunge when the market plunges.
To address some of these drawbacks, consider keeping a mix of index funds and other investments for greater flexibility.
How to Invest in Index Funds
1. Check your 401(k) and IRA
The best place to start investing is perhaps with your office retirement plan. While many people consider their 401(k) as their main savings vehicle, it’s really more of a pre-tax investment account. Putting part of your salary into your 401(k) is as important as choosing where to invest your money. Setting up your 401(k) from your workplace will have you choose your contribution and deferral rate. Your employer will most likely have a limited variety of safe-bet mutual funds that you can choose from.
In case you currently don’t have access to a 401(k) through your employer, you can set up a traditional or Roth IRA through a bank, brokerage firm, or other financial institutions. The key difference between the two is the tax condition, though both will give you access to index funds. Plus, you can also open an IRA while still having your 401(k), in fact, many people benefit from both.
2. Choose an Index
There are hundreds of indexes in the marketplace to choose from, which you can track using index funds. As mentioned earlier, one of the most popular is the S&P 500 index, which is made up of the top 500 companies in the U.S. stock market. Other top indexes include:
- Nasdaq Composite
- Dow Jones Industrial Average
- Russell 2000
- Bloomberg Barclays Global Aggregate Bond
- Schwab Total Stock Market Index Fund
- S&P SmallCap 600
You should note that besides these rather broad indexes, there are indexes tied to specific industries, style indexes that focus on value-priced stocks or fast-growing companies, country indexes that target certain stocks in an individual country, and others based on diverse filtering systems.
3. Choose a Brokerage
Besides IRA and 401(k) accounts, you can invest in an index fund through non-retirement accounts known as brokerage accounts or taxable investment accounts. Once you fund the account, you can buy and sell index funds as you would with mutual funds and ETFs (exchange-traded funds).
Vanguard, Schwab, and Fidelity are arguably the best brokerage providers for mutual and index funds. Each of them has a variety of index funds that you can trade with minimal fees. As such, you may want to do your due diligence to find out which index funds are available at each brokerage before you open or fund your account. Most providers make it easy to do side-by-side comparisons for index funds.
Alternatively, you could consider opening a brokerage account via a robo-advisor such as Betterment, WealthFront, or Ellevest. These robo-advisors enable you to get started investing in a matter of minutes. They typically use computer algorithms to monitor and rebalance your portfolio, and to save you money on taxes.
4. Choose What You Want to Invest In
Index funds can track a given industry (e.g. Tech), asset class (e.g. foreign bonds), or type of company (e.g. mid-sized or large). There are also S&P funds that track the largest 500 companies in the U.S. stock exchange, international index funds that expose investors to international companies, total stock market index funds that feature a large selection of stocks regardless of company size, and bond index funds that track the performance of a representative basket of U.S. Bonds.
Despite the wide array of choices, you may need to only invest in one good index fund. Warren Buffet, who’s perhaps the world’s greatest investor, has repeatedly insisted that the average investor only needs to invest in a broad stock market index in order to be properly diversified.
You should choose an index fund based on your overall risk appetite and the kind of other investments you already have. In general, bonds are regarded as safer than stocks because they don’t fluctuate as often. However, the higher risk of stocks comes with the potential of making higher returns.
5. Consider the Minimum Investment Amount Required
The minimum amount required to buy into an index fund ranges from anywhere between $1 and $3,000. In case the cash you have available is less than the minimum required for the fund you’re looking to buy into, you can take it off your list until you have enough money.
Also keep in mind that while index funds aren’t managed by a team of well-paid fund managers and analysts, they still carry some administrative costs. These costs are usually deducted automatically from each of the shareholder’s returns, usually as fractions of a percentage from the overall investment. And while these might seem negligible, your long-term returns could take a massive hit from even the smallest fee inflation. Naturally, the larger the fund, the lower the fees.
Some of the most important points to know here are as follows:
- Investment minimum: This is the minimum amount needed to buy into a fund. If you meet the criteria, you’ll be allowed to add money in small increments.
- Account minimum: While a broker’s account minimum may be $0 (usually for IRA and 401(k) accounts, this doesn’t remove the investment minimum requirement for the fund.
- Tax-cost ratio: This shows the percentage by which the performance of a fund has been decreased by following taxation.
- Expense ratio: Costs subtracted from each shareholder’s returns as a percentage of their overall investment. It outlines the fee paid to the brokerage firm to manage your investments and is expressed as a percentage of your total account balance.
As a rule of thumb, always choose an index fund with around a 0.5% expense ratio. Whether you’re investing via IRA, a 401(k), or a brokerage account, you should go for an index fund with around a 0.5% or lower expense ratio (or at least below 1%). Since the expense ratio is taken out from your account automatically, it can be really easy to miss.
Keep in mind that a firm with an expense ratio of 0.5% will take $5 for every $1,000 you have in your account balance, annually.
6. Fund Your Account
When investing in an index fund via a 401(k) account, you can choose your investments directly through your provider. You won’t have to invest your total account balance and future contributions in the same fund – your brokerage will allow you to choose how you want to allocate your money.
When investing through a brokerage or IRA account, you can fund your account through your savings or checking account, and make a transfer. When the money is transferred, it will stay in a form of a holding account for some time until you buy into an index fund of choice. You just need to choose the fund, enter the amount of money you’re looking to invest, and then buy.
Another good thing about investing through a 401(k) is that you will already have your contributions set up to be automatic. This is considered a salary deferral. For IRA and brokerage accounts, you are going to need to set it up manually – decide how much to transfer, how often the transfers should happen, and where to direct them (either directly into the fund or the holding account).
It’s always recommended to set up an ongoing maintenance plan and strategy. Although you won’t need to monitor your investments daily (it’s probably not a good idea), you should keep depositing funds ideally on a monthly basis, and rebalancing your portfolio.
Index funds are a wonderful investment vehicle that can not only save you a lot of money but also set a good foundation for your future. A good practice is to add a regular amount into your investment every month, reinvest your dividends, stay the course, and ignore market fluctuations. This way, your index funds will do the heavy lifting for you, and if you end up having a long term, good enough luck, you will reach your retirement goals much sooner than you’d have anticipated.