What Is an Index Fund?
Index funds are stock baskets that follow a specific market index. Popular index funds expose you to the same stocks as the S&P 500, Dow Jones Industrial Average, Russell 2000, and other indices. Each index measures the performance of a specific group of investments, typically stocks, that have a common theme or topic.
How to Invest in Index Funds – A Step-By-Step Guide
Step #1: Pick a Brokerage and Open an Account
You need a brokerage account to invest in an index fund. You can buy and sell mutual funds or ETFs index after your account has been funded. The same underlying stocks and other assets are accessible through both. However, the process for buying and selling them is a little different. Most brokerage firms removed fees for trading ETFs in the fall of 2019. However, some charge as much as $50 for each mutual fund trade. Fidelity, Schwab, and Vanguard are among the top brokerages for mutual fund index funds. You can trade the family of mutual funds offered by these brokerages without paying any fees.
Step #2: Pick your first index fund
If you’re ready to start, the next step is choosing your first index. At first glance, you may want to buy popular S&P 500 funds you saw in the news. However, it’s a good idea to do your research and select the fund and index that fits you the most.
Index funds follow a variety of indexes. One of the most well-known indexes is the Standard & Poor’s 500 index, also known as the S&P 500, which tracks 500 large, well-known U.S. companies from various industries. The S&P 500 is not the only index available, though. Here are some additional choices:
Nasdaq Composite: Tracks over 3,000 stocks listed on the Nasdaq stock exchange and primarily focuses on technology.
Dow Jones Industrial Average: A composite index of 30 blue-chip companies in the United States that covers all industries except transportation and utilities.
Wilshire 5000: Includes all publicly traded companies with US headquarters and available price data; also known as the “total stock market index.”
Step #3: Decide where to buy your index funds
You have two options: you can buy an index fund directly from a mutual fund provider or a brokerage. Exchange-traded funds (ETFs) are also the same. ETFs function similarly to mini mutual funds and trade like stocks all day.
Things you need to consider while choosing an index fund:
- Fund selection
- Trading costs
- Impact investing
Step #4: Monitor your index funds
Index funds have gained popularity as they are easy to use, diversified, and have good investment returns. However, just because they are passively managed does not mean you should ignore them. Points you should keep in your mind as an index fund investor:
- The performance of your index fund should be similar to that of the underlying index. To check, go to the mutual fund quote page and look at the index fund’s returns. It compares the index fund’s performance over time to the benchmark index’s performance. Results do not always need to be identical. Minor investment costs, as well as taxes, have an impact on results. However, red flags should be raised if the fund’s performance lags the index by a significant margin greater than the expense ratio.
- Is the index fund you’re looking for too expensive? If the fees start to add up over time, you may want to reconsider your index fund investment.
- Want to invest in stocks instead? Stocks are a good option if you want to be hands-on with your investments.
Benefits of index funds:
- Index funds save the time you spend researching individual stocks. Instead, you can trust the fund’s portfolio manager to invest in an index that already contains stocks in which you are interested.
- You can invest with a lower level of risk. Most indexes include dozens or even hundreds of stocks and other investments. Diversification lowers the chance of suffering large losses if one or two companies in the index suffer a setback.
- You can purchase stock index funds and bond index funds, which cover the two major components of the majority of people’s investment strategies. However, you can also buy more focused index funds that delve into specific areas of the financial markets.
- Index funds are far less expensive than alternatives such as actively managed funds. Because an index fund manager only has to buy the stocks or other investments in an index, you don’t have to pay them to make their research on other stocks.
- You will pay less tax. Index funds are relatively tax-efficient compared to many other investments. Index funds do not have to buy and sell their holdings as frequently as actively managed funds, so they avoid generating capital gains that can increase your tax bill.
- When you choose index funds, you may invest each month automatically and overlook short-term ups and downs in the knowledge that you’ll participate in the market’s long-term growth. It helps you to stick to your investment strategy.
Drawbacks of index funds:
- You can never outperform the market. Index funds won’t provide you with the opportunity to demonstrate your skill as a superior investor because they are just intended to mimic the performance of the market. There is no loss protection for you. In good times and bad, index funds follow their respective markets, and your index fund will also fall when the market falls.
- You can’t always hold stocks that you enjoy. You can wind up owning some stocks you’d rather not own depending on the index you select while missing out on others you’d prefer.
You can always mix index funds and other investments to provide more flexibility in handling some drawbacks. However, if you just intend to invest in index funds, you’ll need to get comfortable with the limitations.
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