Index funds can be a powerful investment tool. Understanding how to invest in index funds, and the numerous variables one must consider before investing in an index fund, is a foundational piece to your success.
If you’re questioning what index funds are, or how to buy index funds, this article is for you. We’ll be covering everything you need to know regarding investing in index funds.
What Is an Index Fund?
First and foremost, let’s cover exactly what index funds are. An index fund is either an ETF (exchange traded fund) or mutual fund, that holds various securities that are all found within a specific index.
Index funds will invest in various companies that live within a specific index. For example, if someone wanted to invest in an S&P 500 index fund, the specific fund would only hold positions in companies that are found within the S&P 500 index.
The underlying goal of index funds is to match, or beat, the overall return of the market.
How Do Index Funds Work?
Index funds gather money from a variety of investors, and use the gathered money to purchase shares. Index funds allow the investor to capitalize on diversification without having to purchase shares from individual companies.
There are countless index funds on the market today, it’s often a challenge isolating what index funds to invest in.
Why Invest in Index Funds
There are numerous reasons why one may be interested in investing in index funds. These reasons include:
- First and foremost, index funds provide a great deal of diversification. Picking the right security, at the right time, takes a ton of work! If you don’t have time to individually isolate stocks, investing in index funds is a great way to have wide exposure over a specific index.
- Index funds are a more passive investment approach. You do not need to monitor price action daily, listen to every earnings report, or try to time the market.
- There is a cost associated with index funds, however, this cost is often lower than other investment options.
- Last but not least, index funds tend to be less risky than other investments.
Why Not to Invest in Index Funds?
Without question, index funds provide their fair share of disadvantages. The most common drawbacks include:
- Index funds look to mirror the performance of a specific index. If that index goes through a rough economic period, your investment can have a large drawback.
- There are other investments out there that work on beating the overall return the market or an index provides. Therefore, many view index funds as delivering less than ideal returns.
- It’s difficult to find an index fund that invests 100% in securities you like. There will always be a few underperformers in the portfolio which can drag down the overall return.
4 Steps: How To Buy Index Funds
You may be wondering, how can I start investing in index funds? That’s simple! Investing in index funds can be completed in just 4 easy steps.
1. Find a Brokerage
First and foremost, find a brokerage firm to partner with. There are plenty of brokerages to choose from, but careful thought is required to partner with the right one. Here are some things you need to consider:
Some brokerages have less exposure to index funds than others. Be sure to review what index funds a specific brokerage allows you to invest in before setting up an account anywhere.
Low Trading Costs
There are fees associated with purchasing securities through a brokerage. Find a brokerage firm with a fee structure you can tolerate.
Ease of Use / Convenience
Each brokerage firm will use their own software/platforms. Understanding this software/platform can be instrumental to your success.
Also, take into consideration the hours of their customer service team and how easy their mobile app is use. The more convenience, the better!
No- or Low-Commission Fees
Commission fees can erode profit. Be sure to partner with a brokerage that has low or no commission fees.
2. Pick an Index
Now that you’ve isolated which brokerage you’d like to use, it’s now time to pick an index you’ll like your index funds to track. Here is what you need to consider:
Type of Asset
Each index is known for its own unique qualities. Be sure you’re investing in an index that has exposure to the underlying assets you are comfortable investing in.
Company(s) Market Capitalization
The size of companies within a specific index fund is also important. Is the index fund investing in low capitalization companies with great upside potential, or is the index fund investing in large companies with consistent, but less aggressive, growth?
These variables must be taken into consideration when selecting the right index funds.
Domestic / Foreign
Index funds can apply to both a domestic market and foreign market. Some investors may only wish to invest in a domestic market, whereas others may prefer to invest in a foreign market with more upside potential.
Industry / Market Sector
The overall market or industry you’re investing in is also incredibly important. Different industries or market sectors perform better than others.
3. Pick Your Corresponding Index Fund
Once you’ve decided which brokerage platform you’ll be using for your investments, and what index you’d like to invest in, it’s now time to pick your index fund. Here is what you must consider:
The expense ratio is essentially a fee index funds charge. For a passively managed index fund, the fee is typically less than 25 basis points, or 0.25%.
For an actively managed fund, the fee is typically between 50 and 75 basis points, or 0.50 – 0.75%. The higher the expense ratio, the less money you’ll profit.
It’s not uncommon for index funds to have a minimum investment amount. Be sure the fund you’re selecting has a minimum investment amount that you can meet.
Index funds that are purchased outside of tax deferred accounts, such as a 401(k), 403(b) or an IRA, are subject to paying capital gains tax. Keep that in mind when selecting your fund, as taxes must be paid and can quickly erode profit.
4. Buy Shares From the Index Fund
Now that you’ve picked your corresponding index fund, it’s time to purchase shares! Here are some of the best index funds to get started:
Fidelity – FXAIX
Fidelity is well known and respected for the various index funds they offer. One index fund worth considering is their FXIAX fund.
This fund does not have a minimum investment amount, and the expense ratio is low, coming in at 0.015%. This fund indexes the S&P 500.
Vanguard – VTI
The Vanguard Total Stock Market ETF is designed to track the performance of the entire United States stock market. If you are keen on diversifying your investments, this may be a great option for you.
The expense ratio is 0.03% and this is a passively managed fund.
Charles Schwab – SWPPX
Charles Schwab is an iconic name in the investing world, and their SWPPX index fund is well known and respected. This fund indexes the S&P 500 and has an expense ratio of 0.020%.
There is no investment minimum and the fund provides a great deal of diversification.
iShares – IXN
If you’re looking for a global investment option, consider the ETF from ishares, IXN. This ETF provides diversification across the various markets across the globe with an expense fee of 0.43%.
This ETF is strictly focused on technology stocks from some of the most respected technology companies across the globe.
Charles Schwab – SCHM
Another fund worth investing in is Charles Schwab’s mid-cap fund, SCHM. This fund invests in mid-cap companies that provide healthy upside potential.
The expense ratio is 0.040%, and the ETF pays a dividend of 1.03%.
Do Index Funds Belong in Your Portfolio
Index funds have tremendous benefits. Undoubtedly, investing is necessary, but picking the right investments is tough to do!
Trying to time an individual stock takes countless hours of research and studying, and presents a great deal of risk. Index funds help reduce that risk, and certainly help reduce the amount of active studying one must do to generate a healthy return.
Although index funds will never help you get rich quickly, they are a safe investing option that provides a great deal of diversification. A certified financial advisor is someone who can help you with your investments, and can help suggest index funds that fit your objectives and risk tolerance.
Frequently Asked Questions
It is impossible to predict what the future will bring. However, the more time that your money can be in the stock market, the more time it has to grow and compound.
Index funds follow a specific index. If the index goes up in value, the index fund is profitable, whereas if the index decreases in value the fund will also see a regression.
You absolutely can lose money when you invest in index funds, just like any other investment. Nothing is guaranteed when you are investing, even for what is considered one of the safest options, such as index funds.