How to Invest in Index Funds: A 3-Step Beginner’s Guide | Stash Learn
How to invest in index funds: a 3-step beginner’s guide
By: Team Stash
Published: May 29, 2024
• Updated: Sep 19, 2024
In this article:
- How to start investing in index funds
- Pros and cons of investing in index funds
- FAQs about how to invest in index funds
An index fund is a type of investment that tracks a specific stock market index, like the S&P 500 or the Dow Jones. By allowing you to invest in hundreds or thousands of stocks within a single fund, index funds offer an easy way to diversify your portfolio—and most are affordable, too.
An index is a group of stocks, bonds, and other investments that trade on the stock market. So, if you buy an S&P 500 index fund—an index fund that tracks the S&P 500 index—you’d be invested in every company listed on that index. You can also invest in other stock indexes like the DJIA or NASDAQ.
Index funds are great investments for beginners because they allow you to own a wide variety of stocks in one fund. This diversifies your portfolio and is less risky than investing in individual stocks.
If you’re just starting out on your investing journey, don’t fret—investing in index funds is a lot simpler than you might think.
We’ll show you how to do it in three simple steps:
- Choose an index
- Research individual index funds
- Buy your index funds
How to start investing in index funds
1. Choose an index
To invest in index funds, start by choosing the index you want your fund to track. An index is simply a list of securities that represent a subset of the entire stock market.
There are thousands of different indexes tracking just about every sector of the economy you can think of. While any given index may be structured based on various factors, they’re often characterized by capitalization and market sector.
You may have heard of one of the most well-known indexes, the S&P 500. It’s composed of the 500 largest U.S. companies traded on the New York Stock Exchange based on factors like profitability, market capitalization, and trading volume.
Other popular indexes include the Dow Jones Industrial Average (DJIA), a price-weighted index containing 30 of the leading companies in the U.S., and the tech-heavy Nasdaq Composite index.
Here’s a list of other popular indexes and what market segment they track:
- S&P 500: The Standard & Poor’s 500 is one of the most widely used benchmarks in the world for measuring large-cap U.S. stock market performance. It includes 500 of the largest companies in the U.S., representing about 80% of the total market value of all stocks on the NYSE.
- Dow Jones Industrial Average (DJIA): This index, often referred to as just “the Dow,” was created in 1896 and is composed of 30 large, publicly traded companies across various industries. The performance of these 30 companies is thought to reflect the overall condition of the U.S. economy.
- Nasdaq Composite: This index tracks the performance of over 3,000 stocks on the Nasdaq exchange, which is known for its large number of technology and biotechnology companies. It is a capitalization-weighted index, meaning larger companies have a greater impact on its performance.
- Wilshire 5000: This index, also known as the “total stock market index,” includes over 3,500 stocks and covers nearly all publicly traded U.S. equities. It is considered a broad-market index, giving investors exposure to small, mid, and large-cap companies across various industries.
- Russell 2000: This index tracks the performance of about 2,000 small-cap stocks in the U.S. It is a popular benchmark for investors looking to track the performance of smaller companies and can provide diversification benefits when added to a portfolio with larger-cap indexes like the S&P 500.
Reference your investment goals and risk tolerance to help you choose the right index for you. Broad market indexes like the DJIA or S&P 500 are great starting points if you’re new to investing, but you can tailor your choice according to the type of exposure you want for your portfolio and how much risk you’re willing to take on.
2. Research individual index funds
Once you’ve picked your index, it’s time to find a fund that tracks it. For most indexes, you’ll find a slew of associated funds available to choose from, so you’ll need to research your options. In general, this choice mainly comes down to cost.
Index funds can be offered through two main types of investment vehicles: exchange-traded funds (ETFs) and mutual funds. Both options allow investors to gain exposure to a specific index, but there are some key differences between the two.
| Exchange-traded funds (ETFs) | Mutual funds |
|---|---|
| ETFs are similar to stocks in that they trade on an exchange throughout the day at prices that fluctuate based on market demand. They are typically passively managed and have lower expense ratios compared to mutual funds, making them a cost-effective option for investors. ETFs also offer flexibility as they can be bought and sold throughout the day, unlike mutual funds which can only be traded once per day after the market closes. | Mutual funds pool money from investors to purchase a variety of securities, including stocks, bonds, and other assets. They are actively managed by a professional fund manager who makes investment decisions on behalf of the investors in the fund. Mutual funds typically have higher expense ratios compared to ETFs due to the active management and may also charge additional fees such as loads or sales charges. |
When deciding between an ETF or a mutual fund, it ultimately depends on the investor’s preference and investment goals. For those looking for a low-cost, passive investment option, an ETF may be a better choice. However, if an investor wants to take advantage of actively managed funds or have access to specific types of indexes or funds, a mutual fund may be more suitable.
To choose the right fund for you, keep these considerations in mind:
- Expense ratio: This is what you’ll pay in operating expenses each year. You want this to be as low as possible, ideally between 0.05% and 0.15%. For example, an expense ratio of 0.04% means you’ll only pay $0.40 per year for every $1,000 invested.
- How closely the index fund matches the performance of the underlying index: A well-managed index fund should closely mirror the performance of the index it’s tracking.
- Investment minimum: This is the minimum amount you’ll need to invest in an index fund. Some brokerages don’t offer index funds below a certain amount, so if you know you only have $200 to invest, cross off any funds with an investment minimum above that.
- Restrictions: Find out if there are any restrictions or requirements for any fund you’re considering and ensure you meet them.
- Tracking error: This measures how closely an index fund tracks its underlying index. A small tracking error indicates a high level of correlation between the two, meaning that the fund is accurately mirroring the performance of the index. A higher tracking error could indicate that the fund is not as closely following the index and may have additional costs or risks associated with it.
- Historical performance: While past performance does not guarantee future results, looking at a fund’s historical performance can give you an idea of how well it has tracked its underlying index over time. You can find this information on financial websites such as Yahoo Finance or Morningstar.
- Diversification: It’s important to make sure the index fund you are considering is properly diversified. This means that it holds a variety of stocks across different sectors and industries, reducing your risk in case one industry or sector performs poorly. You can usually find information on a fund’s holdings on financial websites or by reading its prospectus.
To help you find low-cost index funds, start by comparing the expense ratios of the funds you’re considering. It’s one of the highest costs of an index fund, so look for the lowest expense ratio possible. Other costs to look out for include trading fees and loads.
| Investor tip: An easy way to vet an index fund is to review its returns over the last year to see how closely it matches the performance of the underlying index. Ideally, it’s nearly identical—this usually means the fund is properly managed. |
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3. Buy your index funds
Understanding how to buy index funds is surprisingly easy once you’ve chosen the index funds you want to invest in.
When it comes to where to buy index funds, you can either go directly through a mutual fund company or open an online brokerage account. The best approach to deciding where to purchase an index fund is to select a provider that aligns with your investment needs and goals.
Suppose there’s a specific brokerage you know you want to purchase an index fund with, like Fidelity or Vanguard. In that case, you can open an account directly with them to avoid paying high transaction fees.
But if you think you’ll be investing in multiple index funds from different companies—for example, maybe you have your eye on both a Vanguard index fund and another index fund offered by Charles Schwab—a catch-all brokerage account that allows you to combine multiple investments in a single place is likely the better option.
| Investor tip: If you want to invest in index funds to build long-term wealth, consider reinvesting your dividends when making your purchase. This help your investment grow and compound over time. |
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Pros and cons of investing in index funds
Investing in index funds is an excellent investing strategy for novice and seasoned investors alike, but like any investment, it’s important to consider their pros and cons.
It’s tough to understate the advantages of index funds. Here’s where they shine:
- Beginner-friendly: Index funds omit the need to research individual stocks, so no prior investment knowledge is required.
- Low risk: A single index fund can hold thousands of stocks from different companies. The low performance of one company in your fund can be offset by the high performance of others.
- Diversification: Index funds allow you to invest in thousands of companies instantly, providing built-in portfolio diversification.
- Low cost: Since they’re passively managed, index funds are cheaper than actively managed mutual funds.
- Allow you to automatically invest: You can set up dividend reinvestments to have your returns reinvested each month, helping you build long-term wealth.
While index funds have plenty of advantages, they’re not always the right investment for everyone. Here are some disadvantages of investing in index funds:
- Less portfolio customization: Index funds offer less control over which stocks and assets you own in your fund. Your index fund may include stocks you don’t want.
- Not immune to market turbulence: Index funds aim to mirror the market’s performance, whether the market is up or down. If the market takes a downturn, your index fund can, too.
- Not ideal for short-term investing goals: When you’re investing for the long term, index funds have enough time to bounce back from short-term market fluctuations. But if your time horizon is only 3–5 years, consider an alternative investment.
Investing in index funds is one of the most effective ways for investors to start building long-term wealth. They’re affordable, offer instant diversification, and let you own a wide array of stocks—all for less risk and within a single investment.
Now that you know exactly how to buy index funds, don’t wait to get started. Remember, building long-term wealth depends on investing regularly and consistently. The sooner you get started, the longer your money has to grow.
FAQs about how to invest in index funds
Are index funds a good investment?
Yes, index funds can be a good investment for building long-term wealth. They offer diversification, low risk, and low cost compared to actively managed funds. However, it’s important to consider your own investing goals and risk tolerance before making any investment decisions.
Is investing in index funds a good idea?
Yes, if you’re looking for a low-cost investment option with built-in diversification. Investing in index funds may be a good idea for people who want a passive investing approach and relatively lower risk, and are not looking to “beat the market” with higher-risk investments.
Why invest in index funds?
Index funds have long been recommended to novice and seasoned investors alike because of their low cost, low risk, and built-in diversification.
Are index funds good for beginners?
Index funds can be a great option for beginners because they require no prior investing knowledge and provide instant diversification. However, it’s important to do your research and understand the pros and cons of index funds before investing.
How can I invest in index funds?
To invest in index funds, you’ll want to choose a benchmark index that aligns with your investing goals, then research individual index funds that track the index you’ve selected. After that, you can buy shares of the index fund through a brokerage, monitor your investments, and rebalance your portfolio as needed to maintain diversity.
How do beginners buy index funds?
For beginning investors, index funds can be a straightforward way to get started. You’ll need to open a brokerage account, then decide which index you’re interested in, research the available index funds, and purchase shares. Keep in mind that not all online brokerages offer index funds, so look for one that provides the kinds of funds you’d like to invest in.