How to Invest in Index Funds

An index fund is an investment that tracks a market index, usually made up of stocks or bonds.

Index funds often invest in all the components that are included in the index they track, and they have fund managers who make sure that the index fund performs the same as the index.

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1. Pick an index

There are hundreds of different indexes you can track using index funds. The most popular index is the S&P 500 Index, which includes 500 of the top companies in the U.S. stock market.

List of some additional top indexes:

  • Large U.S. stocks: S&P 500, Dow Jones Industrial Average, Nasdaq Composite

  • Small U.S. stocks: Russell 2000, S&P SmallCap 600

  • International stocks: MSCI EAFE, MSCI Emerging Markets

  • Bonds: Bloomberg Barclays Global Aggregate Bond

You can find sector indexes tied to specific industries, country indexes targeting stocks in single nations, style indexes that emphasize fast-growing companies or value-priced stocks, and indexes that limit investments based on filtering systems.

2. Choose the right fund for your index

When you have chosen an index, you can find at least one index fund that tracks it.

For popular indexes like the S&P 500, there are more choices all tracking the same index.

If you have more than one index fund option, ask some basic questions.

  • Which index fund most closely tracks the performance of the index?

  • Which index fund has the lowest costs?

  • Are there any limitations or restrictions on an index fund that prevent you from investing in it?

  • Does the fund provider have other index funds that you're also interested in using?

The answers to those questions should make it easier to pick the right index fund to invest in.

3. Buy index fund shares

You can open a brokerage account to buy and sell shares of the index fund you are interested in.

Alternatively, you can open an account with the mutual fund company that offers the fund.

When deciding which way is best for you to buy shares of your index fund, it pays to look at costs and features.

Some brokers charge extra to buy index fund shares, making it cheaper to go directly through the index fund company to open a fund account.

Most investors prefer to have all their investments held in a single brokerage account.

If you anticipate investing in several different index funds offered by different fund managers, the brokerage option can be your best way to combine all your investments under a single account.

Investing in index funds has several advantages including;

  • Tax efficiency

  • Portfolio diversification

  • Reasonable risk

Why invest in index funds?

Investing in index funds is one of the easiest and most effective ways for investors to build wealth.

Simply matching the impressive performance of the financial markets over time, index funds can turn your investment into a huge nest egg in the long run.

You don't have to become a stock market expert to do it.

Investors find index funds useful for many reasons including:

Minimize time spent researching individual stocks. You can rely on the fund's portfolio manager to invest in an index that already includes stocks you want to invest in.

You can invest with less risk. Most indexes include hundreds of stocks and other investments, and the diversification leaves you less likely to suffer big losses if something bad happens to a few companies in the index.

Index funds are available for a wide variety of investments. You can buy stock index funds and bond index funds.

But you can also buy more focused index funds that drill down into certain parts of the financial markets.

It's a lot less expensive. Index funds are far less costly than alternatives like actively managed funds.

This is because an index fund manager just has to buy the stocks or other investments in an index.

You don't have to pay them to try to come up with stock picks of their own.

You'll pay less in taxes. Index funds are quite tax-efficient compared with many other investments.

Index funds don't have to do as much buying and selling of their holdings as actively managed funds.

They avoid generating capital gains that can add to your tax bill.

It's a lot easier to stick with your investing plan. When you use index funds, you can auto invest month after month and ignore short-term ups and downs, confident that you will share in the long-term growth of the market.

You can always keep a mix of index funds and other investments to give you much greater flexibility.

If you plan on using index funds, however, you will have to get comfortable with their limitations.

Why should you not invest in index funds?

Index funds are not for everyone. Some of the downsides of investing in index funds includes:

You'll never beat the market. Index funds are designed specifically to match the market's performance.

If you want to prove your investing skills, index funds won't give you that chance.

You don't have any loss protection. Index funds track their markets in good and bad times.

When the market plunges, your index fund will plunge as well.

You won't always own stocks you like. Depending on the index you choose, you can end up owning some stocks you would rather not own, while missing out on others you would prefer.

Alternative Investment Options

Stocks

Owning stocks of individual companies can be rewarding, but you will need to do some extra research.

Exchange Traded Funds

ETFs are collections of stocks that trade just like a stock, bought and sold throughout the day with fluctuating prices.

Mutual Funds

Mutual funds are a collections of stocks, and they can be actively or passively managed.

Retirement Planning

Properly planning for retirement could be the most important investment decision of your life.

Index funds offer investors of all skill levels a simple, successful way to invest.

If you are interested in growing your money but you aren't excited about doing a lot of research, index funds can be a great solution to help you achieve your financial goals and get rich.

4. Index funds to get you started

If you are looking for some index fund ideas to help you invest better, try the following;

Vanguard 500 Index (NYSEMKT:VOO): which Tracks S&P 500 index

Vanguard Total Stock Market (NasdaqMutFund:VTSAX): Tracks index of U.S. stocks of all sizes

Vanguard Total International Stock Market (NASDAQ:VXUS): Tracks index of global stocks, excluding the U.S.A

Vanguard Total Bond (NasdaqMutFund:VBTLX): Tracks index of various bonds

Vanguard funds are regarded as an easy entry point for new index fund investors. You can find similar funds from other providers, as well.

These four funds let you invest using asset allocation strategies to help you manage risk while getting good returns.