Why bother buying individual stocks when you can buy the entire market?
That’s what you get when you buy an index fund—a reliable and cost-effective way to build long-term wealth that’s suitable for nearly every investor, according to a range of personal finance experts.
An index fund is a group of stocks that track a specific market or sector. For example, an index fund that tracks the S&P 500 would allow you to invest in each of the 500 largest publicly traded companies in the U.S., all at once for a low fee.
Individual stocks may rise and fall over time, and some might vanish entirely. But the entire stock market has a proven record of growing steadily and consistently over long periods of time, and index funds are an easy way to own a piece of that growth.
“I don’t have time to be looking at financial statements all day long. I have to walk my dog. I have to take vacations. That’s why I like index funds. It’s an all-in-one package,” says Delyanne Barros, an investing expert and founder of Slay the Stock Market investing course who says she keeps 85% of her wealth in index funds.
By investing in index funds, your dollar is spread out between many assets, which lower your risk of losing money.
“Index funds tend to be low cost, well-diversified and available to most investors,” says Mark Leong, a wealth management advisor, at Northwestern Mutual.
Here’s what you need to know about an index fund, how to pick an index fund, and how to get started investing.
5 Steps to Investing in Index Funds
You can get started pretty quickly with index funds. But as with any investment, it’s still important to do your own research before making a commitment. Let’s walk through the steps to take when investing in index funds.
1. Set your goal
The way to make money in index funds is with patience and time. “The name of the game here is long-term,” says Barros. For example, the S&P 500 has delivered negative returns in 31% of the years in its history, according to data gathered by Measure of a Plan, a personal finance website. But there hasn’t been a single 20-year period in which it has lost money.
With index funds, “eventually you are going to make money no matter what,” the personal finance expert Suze Orman recently told NextAdvisor. “You’re going to be just fine as long as you have 5, 10, 15 years until you need this money, preferably longer.”
Don’t forget to check on your investments from time to time for fine tuning.
You should also decide how stock-heavy you want to be. The older you are, typically the more conservative your investment strategy will be. But the younger you are, you can afford to be more aggressive with stock index funds, because you are likely to have the money in the market for a longer period of time.
2. Pick an index
There are market indexes that track almost any group of investments imaginable. Some track large companies, like the S&P 500. Others track international stocks, such as MSCI Emerging Markets. Indexes can also track other investments, like bonds or currencies. If you’re just starting out, picking a broad-based index fund that covers the entire stock market, like the S&P 500, is a good place to start. “Every broker offers one. Look for the one that says S&P 500 or total stock market,” says Barros.
3. Pick a fund
After you find the index you’re interested in, there are usually at least a few options for funds that track that index. Different funds that track the same index will generally have very similar performance histories. But there could be a meaningful difference in their fees. Look for index funds that have the lowest fee, also known as an expense ratio. Some index funds, like those from Fidelity, could even have expense ratios of zero. “That’s music to the ears of an index fund investor,” says Barros.
4. Buy shares
To invest in an index fund, you need to buy shares of that fund. You can invest in index funds through a taxable brokerage account or through tax-advantaged retirement accounts, like your 401(k), or traditional or Roth IRA.
“You have to go in there and look for the index fund when you’re setting up your retirement accounts,” says Barros. “You can tell something is an index fund by the title, if it says index, or by the low or non-existent expense ratio. If the expense ratio is 0.1% or below, it’s probably an index fund.” Some, but not all, brokerage accounts require a minimum investment to get started.
5. Follow up and keep investing
Experts love index funds because they’re easy to manage—you don’t need to do much day to day. But that doesn’t mean you should buy index fund shares then forget about them. Depending on your investment goal, decide how much you’d like to continue investing every month. “For instance, if you’re pursuing financial independence, you can find a compound interest calculator online and run your numbers. If you want to hit your financial independence number in 30 years, you need to invest X amount a month. You can divvy it up through your multiple accounts, but be sure to prioritize your retirement accounts first,” says Barros.
Pros of Investing in Index Funds
- Diversification – With index funds, you can buy one share but have investments in many different assets. This allows you to balance your risk between a range of investments.
- Lower fees – Index funds are generally passive, so the fees they charge are almost always lower than funds that are actively managed.
- Proven success – Time and time again, index funds outperform actively managed mutual funds with higher fees. And they are a more predictable, stable investment than alternative assets like crypto. “Some people comment on my videos and say, ‘I made 3,000% return on crypto.’ But crypto crashed, and index funds are up 15%. This is what I’m talking about,” says Barros. Over its history, the S&P 500 has delivered an average annual return of 8.4%, according to Measure of a Plan.
Cons of Investing in Index Funds
- There will be down days – Just like any investment, there will be down days. But it’s important to keep that long-term mentality in mind. Over long periods of time, total market index funds have a record of gaining value.
Other Investment Methods
Index funds are a simple and inexpensive way to diversify your investments. But there are plenty of other options available, as well. Here are a few other investments to consider.
When you buy a share of a single stock, you are buying a piece of the company. When the company does well, the price of your shares increases. When the company performs poorly, the opposite occurs. Your investment in a company’s stock is directly tied to the company’s financial performance. Be sure to diversify your stock portfolio to protect your investments.
A bond is essentially an IOU. When you buy a bond, you’re lending money to a borrower. That borrower might be a government or a corporation, and they promise to pay the money back, plus interest. When the bond “matures,” the borrowing term is over, and you’ll get your investment back with the accrued interest. But you can sell the bond before it matures. There are index funds that track bond markets, just like there are index funds that track stock markets. Keep in mind that bonds have historically provided lower long-term returns when compared to stocks.
Active mutual funds
Some people prefer to have investment managers take an active role in managing their investments. With an active fund, you can rely on the expertise of an investment manager with the hopes that they’ll be able to beat the market. But you’ll generally pay higher fees with an active fund, and active funds tend to underperform the market over long periods of time
Index Funds to Get Started With
Investing styles and tactics are highly dependent on personal preferences. But to start out, you can try an index fund that tracks the S&P 500. The S&P 500 tracks 500 of the largest publicly traded companies from across sectors. Because these companies make up such a large share of the economy, the S&P 500 closely follows the movement of the entire stock market.
Three well-known index funds that track the S&P 500 are Schwab S&P 500 Index Fund (SWPPX), Vanguard 500 Index Fund – Admiral shares (VFIAX), Fidelity 500 Index Fund (FXAIX).
“There isn’t a single solution for everyone,” says Leong. “My advice for a new investor would be to develop a holistic plan based on your long-term goals and create a portfolio that aligns with those goals and your risk tolerances.”
Are index funds risky?
Although index funds help to diversify your investments (which can offset risk), all investments can be risky. But investing in a total market index fund over a long period of time is as close to guaranteed success as you’re going to get. There isn’t a single 20-year period in the S&P 500’s history when it lost money.
Where can I buy index fund shares?
Index funds shares can be purchased online at a discount brokerage firm such as Vanguard, Fidelity, or Schwab. You can also invest in index funds through most employer 401(k) plans and within tax-advantaged accounts such as traditional and Roth IRAs.
Do index funds charge fees?
Many index funds charge fees in the form of a percentage of the total value of your mutual fund shares. This is called the fund’s expense ratio. However, there are some index funds that do not charge fees at all.