How To Invest In Index Funds For Beginners

Index fund investing can be great for beginners. Index funds often charge low fees, require little maintenance and can provide built-in diversification for your portfolio if chosen wisely. Index funds often aim to track the performance of an index such as the S&P 500.

These funds are typically passively managed, not selected by a human fund manager. So the biggest trade-off investors make with index funds is giving up control over that piece of their portfolio. We’ll walk you through how to buy the best index funds and reap some of the key benefits.

What is an index fund?

An index fund is a mutual fund or exchange-traded fund (ETF) that aims to match the performance of an index like the S&P 500, the Dow Jones Industrial Average or other international stock and bond indexes. If you invest in an S&P 500 index fund, for instance, you can expect the fund to closely mirror the performance of the index. Investors often use a combination of funds to diversify their portfolios.

You can buy index funds as either mutual funds or exchange-traded funds. Mutual funds may be available through your 401(k) but for ETFs, you will likely have to invest on your own. 

How to invest in an index fund in 3 steps

Buying index funds is a simple process. Thanks to online brokers, you don’t need much to get started, and you can do so in just a few minutes.

1. Choose a broker

Your first step is to decide where to invest your money. You can either open an account with the broker that offers the fund you want or simply open an account with your preferred broker. Many of the major brokers offer their own index funds, but they tend to largely track the major indexes, so performance should be similar across brokers.

However, some small differences between brokers could impact your decision.

• Vanguard is investor owned, which is important to some investors. 
• Fidelity’s website is generally considered easier to use.
• Charles Schwab offers a mix of research tools and solid customer service.

Picking the right broker is about deciding what is most important to you.

Whatever you decide, opening an account with an online broker allows you to invest your money however you want. You will likely have access to thousands of index funds. Plus you can usually open either a brokerage account or a retirement account, such as an individual retirement account (IRA).

2. Pick your index fund(s)

The next step is to decide which fund or funds will get your money. Some of the most popular index fund choices include:

Most savvy investors would likely avoid investing in both the S&P 500 and U.S. total stock market funds because the latter includes the former. The S&P 500 comprises about 500 of the largest publicly traded companies in the U.S., while a total stock market index tracks all U.S. publicly traded companies.

Beyond this, the way you allocate your money is a personal choice.

3. Buy shares of an index fund

Once you have picked your broker and chosen your fund(s), the hard work is done: all you have left to do is buy your shares. However, if you decide to invest in multiple funds, you still have to decide how much to invest in each fund type.

In general, younger investors planning for retirement should consider putting a larger allocation of their portfolio in higher-risk investments, such as stocks, since they have more time on their side before they need the money. The closer someone is to retirement, though, the more they may want to consider shifting a larger chunk of their holdings into bonds or other lower-risk assets since those are less likely to lose value in the short term.

Pros and cons of investing in index funds

Index funds are ideal for new investors, but they have their fair share of advantages and disadvantages.

Pros of index funds

• Low fees. Index funds simply track an index; they are not actively managed. This allows fees to stay low, with some index funds charging no fees at all.
• Built-in diversification. Index funds that track a broad index are inherently diverse. For instance, an S&P 500 fund allows you to own a small piece of about 500 of the largest companies in the U.S. across different industries. Thus, these funds provide instant diversification.
• Minimal maintenance. When you buy index funds, rebalancing your portfolio may be less needed. If you were to put all of your money in a single index fund (not necessarily recommended), the fund itself handles all of the shifting allocations for the constituents in the index.
• Tax efficiency. Because index funds are not actively managed, they buy and sell stocks infrequently. This helps reduce capital gains taxes you might otherwise incur.

Cons of index funds

• No ability to select stocks in the index. For beginners, it can be nice having everything done for you. But more advanced investors often prefer to hand-select their stocks — something that isn’t possible with index funds.
• Can be less diverse than expected. Index funds are often market-cap weighted, meaning they invest more of their money in companies with higher market caps. So larger companies make up a bigger share of a given index.

FAQs

• How can I directly invest in index funds?
  

  Investing in index funds is fairly straightforward. Once you have a brokerage account, choose the index fund(s) that best fits your investing goals — retirement, growth, income, etc. — and place your order as you would for a stock trade.

• How can beginners invest in the S&P 500?
  

  From your brokerage account, choose a fund that tracks the S&P 500, such as the Vanguard S&P 500 ETF (VOO), the SPDR S&P 500 ETF (SPY), iShares Core S&P 500 ETF (IVV) or Fidelity 500 Index Fund (FXAIX). Purchase shares in the fund as you would an individual stock.

• Which index fund is best?
  

  Finding the best index fund depends on your investing goals.

  • The VOO, mentioned above, is a popular low-cost ETF, highly liquid, long-term fund.
  • The FXAIX is a mutual fund with a very low expense ratio, making it a good pick for retirement account investing.
  • The Schwab S&P 500 Index Fund (SWPPX) can be a great mutual fund for beginning investors due to its low expense ratio and no minimum investment requirement.
  • The IVV is a very tax-efficient ETF.

Bottom line

There’s a lot to like about index funds, including low fees, low maintenance and built-in diversification. It’s easy to start investing with an online broker, and you only need a handful of funds to start a portfolio. Index fund investing is one of the simplest ways to get your money into the market. These funds might not be as sexy or exciting as day trading stocks, but as legendary investor Warren Buffet says, “Index investing is the way to go for most people.”

— Kim Husband contributed to an update.

Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making an investment decision. In addition, investors are advised that past investment product performance is no guarantee of future price appreciation.