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Index funds allow you to invest in the wider stock markets, which means you don’t need to decide which individual shares are best suited for your portfolio when utilizing this instrument.
The most prominent index funds to consider are those that track the S&P 500 and Dow Jones but many other options exist out there. Most importantly, through a single index fund investment, you will indirectly own dozens or even hundreds of financial instruments.
In this guide, we explain how to invest in index funds from the comfort of your home. We also discuss how index funds work, which type of investor they are suited for, and which risks they come with.
How Do Index Funds Work?
Before you consider how to invest in index funds, you should first understand how this financial instrument functions. In its most basic form, an index fund will track a specific segment of the market.
For example, the S&P 500 tracks the value of 500 large US companies that are listed on the NYSE and NASDAQ. The Dow Jones tracks 30 blue-chip stocks from a variety of US sectors and industries. Then you have the likes of the FTSE 100, which tracks the 100 largest companies listed on the London Stock Exchange.
Crucially, by investing in an index fund, you are indirectly buying a basket of stocks. This cuts out the need to research and analyze the performance of individual companies.
With a key exception being the Dow Jones, most index funds are weighted based on market capitalization.
For example, the S&P 500 is heavily weighted towards the likes of Apple, Amazon, and Microsoft — as they have a much larger valuation than other stocks in the index. Most index funds are rebalanced every three months, as well.
For example, if a stock loses a considerable amount of market capitalization, this will be reflected in its index fund weighting. Or, in more drastic cases, a stock might be replaced entirely. This is what happened to Exxon Mobile recently when the Dow Jones replaced the stock with Salesforce.
It is important to note that while most investors will opt for an index fund that tracks an area of the wider stock markets, alternative options are also worth considering. This includes index funds that track a basket of dividend stocks, corporate bonds, or government securities.
Note: Index funds have a number of advantages and benefits including lower costs, broad-based diversification, and lower taxes compared to other instruments.
Investing in Index Funds in Four Simple Steps
So now that you know how index funds work, we are now going to walk you through the investment process. It begins by selecting an index fund that is right for your financial goals and tolerance for risk.
Step 1: Pick an Index Based on Your Investment Goals
There are many types of index funds on the market — most of which can be accessed via an online broker. You do, however, need to think about what your investment goals are and how much risk you are willing to take to get there.
For example, are you looking to invest in a specific market like the NASDAQ or the London Stock Exchange? If so, you’d want to invest in an ETF that tracks the Nasdaq Composite or the FTSE 100. Or perhaps, you’re looking to focus on a basket of solid chip stocks that pay dividends? If so, the Dow Jones could be a good option for you.
You might even consider investing in an index fund that gives you access to a diverse basket of international stocks. There are many options in this respect, some of which cover stocks from multiple continents.
You will also need to think about the type of financial returns you want to focus on. For example, if your regular income is what you seek, it’s best to consider an index fund that focuses on high-yield dividend stocks or bonds. If you’re more interested in long-term capital gains, index funds that hold a basket of growth stocks could be of interest.
In terms of risk, you will need to make a judgment based on the types of assets and markets that the index fund is involved in. For example, by investing in stocks and bonds located in the emerging markets, the risks and potential rewards are going to be on the high side.
At the other end of the scale, a conservative investor might decide to stick with an index fund that tracks high-grade bonds and US Treasuries. Naturally, the potential returns on these offers are going to be much lower — fully in line with reduced risk levels.
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Step 2: Choose an Index Fund
Once you have assessed which type of index fund interests you — ensuring that it meets your investment goals and attitude to risk – it’s then time to look at the fundamentals. After all, there are dozens of established ETF and mutual fund providers that offer index funds, all of which come with various historical returns, expense ratios, account minimums, and objectives.
Let’s explore these key points in a little more detail:
You first need to assess what the minimum investment requirement is. Ultimately, this will depend on whether you go direct with the index fund provider (e.g., Vanguard or iShares) or through an online broker. Either way, just make sure the minimum falls in line with your investment budget.
It’s then a good idea to look at the past performance of the specific index fund. This is important, as the fund will not always replicate the performance of the benchmark it is tracking.
On the contrary, there is always likely to be a slight variant. The most important thing is that the index fund isn’t generating returns that are considerably less than the respective benchmark.
All index funds will charge an expense ratio. This is essentially the amount of money you will need to pay each year in management fees. Expressed as a percentage, the amount is multiplied against the value of your investment.
For example, if the index fund charges 0.5% annually and you invest $10,000, you’ll pay a fee of $50.
As most index funds generate income, you’ll want to check the frequency at which distributions are made.
Dividends are usually paid quarterly, although some index funds do this on a month-by-month basis. The latter will enable you to reinvest your dividends at a much faster rate.
Important: Keep in mind that index funds are not immune to market swings, losses, and risk. You should also keep in mind that not all index funds are created equal, thus some perform better than others.
Step 3: Select Where to Buy From
Although many index fund providers allow you to invest directly through their website, it’s always best to go through an online broker. This is because brokerage sites are more geared towards retail investors, meaning that account minimums are often much lower.
There are, of course, many online brokers that give you access to index funds, so it’s important to choose wisely.
The most important considerations to make are as follows:
Reputation and Safety
First and foremost, you need to ensure that your chosen index fund broker has a solid reputation. At the forefront of this is the regulatory standing of the broker. Age-old brokerage firms like Charles Schwab, Fidelity, and TD Ameritrade are popular in this respect — as they have been around for several decades.
Commissions and Fees
As such, many online brokers allow you to invest in US-listed index funds on a commission-free basis. This means that the only fee payable is the expense ratio of the index fund provider.
In other cases, you might need to pay a flat fee every time you enter or exit an index fund investment. Some online brokers will also charge an ongoing platform fee of their own, which is in addition to the expense ratio.
Your chosen broker must offer the index fund(s) that you wish to invest in. It’s always good when the broker offers a wide selection of funds, as this gives you the best possible chance of diversifying.
Most online brokerage sites offer a selection of account types to choose from. In particular, it’s worth choosing a broker that offers tax-efficient accounts — such as a traditional IRA or Roth IRA. This is especially the case if you are looking to build a long-term portfolio for your retirement years.
Pro tip: An index fund will do as well as the index it represents, so make sure you select a good index to track and invest in.
Step 4: Automate, Monitor, & Rebalance
Once you have completed your first index fund investment, you then need to look at the longer-term picture. Sure, index funds allow you to invest passively. But, if you want to take things to the next level and ensure that your money continues to work for you, think about monitoring your investment on a semi-regular basis.
Ultimately, this is to ensure that your index funds are performing the way that you want them to. If not, then it might be worth rebalancing. This simply means reducing your exposure to a particular index fund or replacing it with an alternative investment altogether.
Perhaps the best thing that you can do is consider a more structured dollar-cost averaging strategy. This will see you commit to a regular investment plan.
For example, if you can afford to invest $100 each month, you might consider putting $65 into an index fund as each week passes. In doing so, you will invest at a different cost price and avoid the stress of short-term volatility.
And of course, don’t forget about the importance of creating a dividend reinvestment plan. Once again, this means reinvesting your dividends back into the financial markets as soon as you receive a payment.
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Benefits of Index Funds
To recap, the main benefits of investing in index funds are as follows:
- Invest in a full basket of stocks through a single trade
- Some give you exposure to corporate bonds and government securities
- Create a highly diversified portfolio
- Most come with a very low expense ratio
- Thousands to choose from
- Suit all investment goals and attitude to risk
Downsides of Index Funds
There are, of course, also several downsides to index funds, such as:
- You will have no say in which assets are bought and sold
- They typically track a market, meaning that they will get dragged down by a wider downfall
- Index funds are generally managed passively, so you might be missing out on more attractive gains
- Can underperform the benchmark they are tracking
FAQs About Investing in Index Funds
We’ve found some of the most frequently asked questions with regards to how to invest in index funds. Here are our answers.
What Is the Difference Between Index Funds and Actively Managed Funds?
If an index fund is actively managed, it will look to outperform the benchmark it is tracking. For example, instead of investing in all 500 stocks from the S&P 500, the index fund might look to eliminate companies it believes will underperform.
With that said, most index funds are passively managed, especially when backed by an ETF. This means that the index fund will look to track the respective benchmark like-for-like.
How Do I Make Money with Index Funds?
To invest in an index fund, you will need to do so via an ETF. For example, if you wanted to invest in the S&P 500 index, there are ETFs offered by Vanguard, iShares, SPDR, and many others. You can also consider a mutual fund, which will offer more flexibility in the specific assets being bought and sold.
Either way, there are generally two ways in which you make money from an index fund investment:
- NAV: When the value of assets being tracked by the index fund collectively rises, this will be reflected in the NAV (Net Asset Value) of the respective ETF or mutual fund. In simple terms, if you invested $10,000 into the Dow Jones and the index increases by 5%, your capital would now be worth $10,500.
- Dividends: Assuming your chosen index fund consists of a variety of income-generating assets, you’ll also be entitled to your share of any dividends. This would include stocks that pay dividends or fixed-income bonds.
Pro tip: It’s always best to reinvest your dividends back into the financial markets on receipt. In doing so, you’ll benefit from the long-term impact of compound interest.
Who Should Invest in Index Funds?
Index funds are suited to investors that wish to invest passively. This financial instrument is also craved by those that wish to invest in a highly diversified basket of assets from a variety of markets.
Mutual Funds vs. ETFs for Index Funds: Which Is Best?
Whether you opt for a mutual fund or ETF when investing in an index fund is largely dependent on whether you want to track a specific market or attempt to outperform it. Mutual funds will typically seek to actively outperform the market while ETFs will look to mirror it passively.
Are Index Funds a Good Investment?
Certain index funds — such as those that track the S&P 500 or Dow Jones – have time and time again proven that they represent an excellent long-term investment.
In the case of the S&P 500, for example, this stock market index has generated average annualized returns of over 10% since it was launched in 1926. This is particularly impressive when you consider the number of stock market recessions we have witnessed over the past century.
In summary, index funds allow you to invest in a diversified basket of stocks from various sectors and industries. There are also index funds that track corporate bonds and government securities, should you wish to diversify away from the stock markets.
Either way, through a single trade you have the chance to indirectly own hundreds of individual assets. Best of all, most index fund providers allow you to generate financial returns in two ways: regular dividends and capital growth through an increased NAV.
Just make sure you perform lots of research when choosing an index fund as there are thousands of options in the market. In particular, focus on what your long-term financial goals are and how much risk you feel comfortable taking.
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Kane is a highly-skilled researcher and writer with expertise in finance, trading, and cryptocurrencies. Academically, Kane holds a Bachelor’s Degree in Finance, a Master’s Degree in Financial Crime, and he is currently engaged in a Doctorate. He is passionate about researching the money laundering threats of the virtual economy — notably, cryptocurrencies and blockchain technology.