How to Invest in Index Funds

Investing is an important part of saving for the future -- especially for retirement. However, it can be difficult and stressful to know how to invest and what to invest in.

Index funds are a type of mutual fund that aims to make investing easier. Index funds are inexpensive and aim to track a specific market index, like the S&P 500, which means you don’t have to make bets on specific industries or sectors of the market.

Index funds have become very popular in recent years. If you want to start investing in them, it’s easy to do.

What is a Mutual Fund?

A mutual fund is a security that makes it easy to diversify your investments.

Many investors want to build a diverse portfolio that holds a wide array of stocks and bonds. Putting all your money into one company can be risky. If that company fails, you lose your entire investment. If you split your money between 20 different businesses, one failing means you only lose a small portion of your investment. Splitting your money between even more stocks can further reduce your risk.

The problem is that diversifying your investments can be hard. The price to buy a single share in some companies can be thousands of dollars. If you want to buy a single share in 100 different businesses, you might need thousands or tens of thousands of dollars to do so. Plus, you’ll have to pay any commissions and other fees for every single transaction.

Mutual funds do all the hard work for you. You can buy shares in one mutual fund that then buys shares in dozens or hundreds of companies on your behalf. You only have to worry about buying one thing while getting the benefits of diversification.

Mutual funds charge a fee for this service: an expense ratio. This fee covers the cost of managing the fund and is expressed as a percentage of the money you have invested. For example, if you have $10,000 in a mutual fund with a 0.50% expense ratio, you pay $50 each year to invest in the fund.

Mutual funds have a huge variety of different investing strategies. Some focus on specific industries, like consumer staples, manufacturing, or technology. Others hold only bonds issued by large corporations. Index funds track specific market indexes.

Some mutual funds are actively managed. With these funds, the managers look for investment opportunities that they feel will provide the best possible return. Because this is difficult, actively managed funds tend to have a high expense ratio. As of 2018, the average fee was 0.67%. These fees can have a huge impact on your performance over time. However, proponents of actively managed funds argue that they offer higher returns and reduce losses during poor markets.

Learn More: How to Start Investing?

What is an Index Fund?

An index fund is a type of mutual fund that focuses on tracking a specific market index. Market indexes, like the S&P 500, are meant to represent a broad swath of the market. For example, the S&P 500 includes 500 of the largest companies in the United States.

The Russell 2000 tracks 2,000 small, publicly-traded companies.

Unlike actively managed funds, which try and outperform the market as a whole, index funds aim to follow the market. If the S&P 500 gains 10% in a year, S&P 500 index funds aim to gain the same 10%. If they lose 5% in a year, the index funds lose 5%.

Unlike actively managed funds, which require a lot of input and decision-making from fund managers, index funds are very easy to manage. The managers don’t have to make decisions about what shares to buy and sell. Instead, they have to handle customer requests to buy and sell shares while making sure they maintain an allocation of shares that lets the mutual fund accurately track its target index.

This means that index funds tend to have much lower expense ratios than actively managed funds. As of 2018, the average fee for passively managed funds was 0.12%.

Proponents of index funds argue that in the long run, the majority of fund managers cannot beat the market as a whole. That, combined with the higher fees that you’ll pay for an active fund means that index funds offer better returns over the long run.

Benefits of Index Funds

There are a number of benefits to investing in index funds.

Easy

One of the primary reasons to invest in index funds is that it’s incredibly easy. Choose a fund provider, preferably one that charges low expense ratios, and start buying shares. You can build a solid, diversified portfolio with just a few index funds. Popular strategies include one index fund that focuses on stocks and one that focuses on bonds or adding an additional fund or two to include international stocks and bonds.

Because you’re only investing in one (or a few) funds, you can easily split your investing money between the shares. You don’t have to research dozens of different companies to decide which ones represent good investment opportunities and you don’t have to worry about balancing your portfolio among dozens of investments.

Low-cost

Index funds are one of the cheapest ways to invest in the stock market. The average expense ratio is 0.12%, which means you pay just $12 for every $10,000 you have invested.

Some brokerages charge commissions every time you want to buy and sell stocks or bonds. If you pay a $3 fee for each transaction and want to build a portfolio that includes 50 different companies, you’ll pay $150 just to set up the portfolio, plus an additional fee every time you buy or sell additional shares.

Typically, brokers don’t charge a commission if you’re investing in their index funds. Even if they do, you’ll only pay one commission instead of dozens, which saves you money.

Related: Best Online Discount Brokers

History of performance

Vanguard, one of the top index fund providers, regularly publishes research regarding the performance of actively managed and passively managed funds. While some actively managed funds do perform well, it has been historically incredibly difficult for an active fund to beat the market, especially after accounting for fees.

In general, index funds have outperformed actively managed funds in the past. However, there’s no guarantee that future results will mirror previous performance.

Drawbacks of Index Fund

Index funds have a lot of pros, but there are some downsides to consider.

Potential for less investment growth

Index funds aim to track the market, which means that you won’t be beating the market by investing in them. If you choose your own investments or buy shares in an active fund, there’s always the chance you’ll buy shares in the next Disney, Amazon, or Walmart and grow your investment by a huge amount.

Lack of flexibility

Most index funds work to track the market by holding a huge variety of stocks. This leaves you with less flexibility to build your own portfolio. You wind up owning whatever the index fund owns.

Some people want to avoid owning shares in specific types of companies, such as fossil fuel businesses or companies that sell things like alcohol or tobacco. Other investors want to hold more shares from businesses in specific sectors, such as technology.

With index funds, you don’t have as much flexibility to design your portfolio the way you want to. You have to accept the portfolio built by someone else.

Tracking errors

The point of index funds is to track a specific index, but there’s no guarantee that they actually succeed at this task. Many index funds only hold a small subset of the shares in an index that is representative of the activity of the entire index.

Holding fewer shares than exist in an index helps to reduce costs for the fund, but can result in tracking errors. Sometimes, the shares the fund holds won’t represent the index’s overall price movement. The index fund might underperform the index because of these tracking errors.

There are a few key steps when starting to invest in index funds.

Decide on the Right Type of Account

The first thing is to choose the type of account that you want to open.

Anyone can open a taxable brokerage account. These accounts are flexible -- you can add and withdraw funds at any time. However, you have to pay capital gains taxes on the money you make from your investments.

If you’re trying to save for retirement, you have the option of opening a traditional or Roth IRA. IRAs limit your contributions and restrict your ability to withdraw money until you turn 59 but give you tax advantages.

With a traditional IRA, you can deduct contributions from your income when filing your tax return, meaning you pay less tax. You pay income tax on withdrawals instead.

With a Roth IRA, you pay tax as normal when contributing, but pay no tax on withdrawals. That means you don’t pay any taxes on earnings from your investments.

Typically, Roth IRAs are best for people in lower tax brackets and traditional IRAs are best for those in higher brackets.

If you’re not saving for retirement, a taxable brokerage account is usually the way to go.

Select an Online Broker

There are dozens of companies that offer brokerage accounts, so compare the options to find the best one for you. Many brokerages have their own line of index funds and offer perks, like reduced commissions, for investing in their funds. If you know which funds you want to invest in, see if the fund manager also runs a brokerage company.

Ally Invest

Ally Invest is the investing service offered by Ally Bank. The company doesn’t offer its own index funds but does offer commission-free trading for stocks, bonds, ETFs, and mutual funds, making it a good choice for cost-conscious investors. If you want to be hands-off, there’s also a robo-portfolio service with a $100 investment minimum.

Of course, if you also bank at Ally, keeping all your money in one place is convenient, giving you more reason to use the service.

You Invest by J.P. Morgan Chase

You Invest is a self-directed brokerage account with no account minimum. You can trade stocks, bonds, ETFs, options, and index funds commission-free. You can also use the company’s smart portfolios service, which includes professionally-designed and managed portfolios. This service has a $500 account minimum and a 0.35% fee annually.

E*TRADE

E*TRADE is a popular discount brokerage for those who want to do most of their investing online. The company doesn’t offer its own index funds but lets you invest in other companies’ funds with no transaction fee, so long as you hold your shares for at least 90 days. Given that you’re investing in index funds, this shouldn’t be much of an issue.

TD Ameritrade

TD Ameritrade combines self-directed and managed portfolios in one broker. You can manage your own money, buy index funds of your choice, or let TD Ameritrade manage your investments for you.

For no-load mutual funds, there is no transaction fee or commission, making TD Ameritrade a good choice for people who are planning to invest in index funds.

Paladin Registry

Paladin Registry isn’t a brokerage itself. Instead, it’s a company dedicated to helping people find financial advisors that fit their needs. Many financial advisors build actively-managed portfolios and charge high fees. Using Paladin Registry, you can find one that will help you execute an indexing strategy.

Determine your Initial Deposit

When choosing a broker, you have to decide how much money you want to invest. Most brokers and mutual funds have a minimum deposit. Usually, the minimums are between $1,000 and $3,000.

There are two primary strategies when it comes to choosing how much to invest. You can invest all of your investable money in a single lump sum or you can space it out over a period (also called dollar-cost averaging).

For example, someone who has $24,000 might decide to dollar cost average, investing $2,000 per month for 12 months. This helps reduce some of the impacts of volatility, especially significant drops right after you start investing, compared to investing all $24,000 at once. However, historically, lump-sum investing outperforms dollar-cost averaging more often than not.

Ongoing Strategy and Maintenance Plan

Once you open your account, you need to do some ongoing maintenance. If you’re using multiple funds to build a portfolio that holds both stocks and bonds, that means rebalancing your assets every so often.

You’ll also probably continue adding funds as you make more money and have the extra assets to invest. Knowing how you plan to do your rebalancing (semi-annually, annually, etc.) and how you’ll add additional money to your investments can help make maintaining your portfolio easier.

Frequently Asked Questions

Here are some frequently asked questions about index funds.

Can you lose money with index funds?

With any investment, there are risks. When you invest in an index fund, there is a chance that you’ll lose money. Index funds aim to track the performance of a stock index. If the index rises, the fund should increase in value. If the index falls, the fund should lose value. Because investing is subject to risk, you should only invest once you have an emergency fund and stable finances.

Can index funds make you rich?

Though the definition of “rich” is relative, investing in index funds is a great way to build wealth over the long term. Consider a 25-year-old investor who decides that they want to use index funds to save for retirement. Each year, the investor puts $10,000 into S&P 500 index funds. By the time they turn 65 and retire, the investor will have put $400,000 into the account. If the fund returns 6% per year on average, the investor will have $1,650,470 in the fund, a gain of more than $1,200,000 on the amount invested.

Do index funds pay dividends?

Index funds can pay dividends, but not all index funds do. If you want to earn dividends from your investment, you can choose an index fund that does offer regular dividend payments. Keep in mind that you pay taxes on dividends as you receive them, but only pay taxes on investment gains when you sell the investment. That can make funds that pay dividends slightly less tax efficient.

What is a target date fund?

A target date fund is a type of mutual fund that is designed to help people save for retirement. Typical advice is that investors should reduce their portfolio risk as they get closer to retirement. Target date funds handle this risk reduction for you. You choose a fund based on the year you plan to retire. For example, if you hope to retire in 2060, you can choose a Target Date 2060 fund. As time passes, the fund managers reduce the portion of the fund that is held in stocks and increases the fund’s bond holdings. Many target date funds hold index funds, which keeps costs low and provides a diverse portfolio.

Bottom Line

Index funds are a great way for investors to build a diverse portfolio without paying high fees. Most index funds charge low fees and do a good job of tracking their chosen index, meaning you can feel confident that your portfolio will follow the market’s performance without significantly over or underperforming it.