How to Invest in Index Funds – A Beginners Guide
Index Funds gives you the opportunity to invest in different companies at the same time. It is one powerful way of diversifying your investment, reducing risks and the cost of investment, yet it still holds potentially good returns.
In this days that many people have fear of investing in stock, index funds has become the preferred investment option. By the way, why will you even want to buy an individual stock when you can have the whole market? Yes, that is what index funds is all about.
However, investing in index funds requires one to have a clear understanding of how it is done. Fortunately, there is a guide, even for beginners. In this post, I shall give a detailed guide of how to invest in index funds even if you are a beginner.
What Is an Index Fund?
An index fund is a type of mutual fund that aims to track a market index. A good and very popular example is the S&P 500. Another one is the Russell 2000.
Because the aim of an index fund is to duplicate the makeup of a market index, there are lower costs to own an index fund. While many other types of mutual funds pursue an active investing strategy, with fund managers picking winning investments, index funds are considered to be a form of passive investing.
The overall long-term performance of index funds has historically exceeded that of actively managed funds.
How Do Index Funds Work?
Like we have said before, index fund pools money from many investors to buy a diversified portfolio of stocks, bonds or other assets.
Each share of the index fund represents an investor’s proportionate ownership of the fund’s portfolio and the income the portfolio generates. Index fund shares are typically purchased in different investing accounts, like an individual retirement account (IRA) or a brokerage account.
What’s the Difference Between an Index Fund and an ETF?
The biggest difference between an index fund and an ETF is the way each is traded (bought and sold). An ETF is traded like a stock. This means you can buy and sell it at will anytime of the day. On the other hand, an index fund can only be bought and sold at the price set when the trading day ends.
Like index funds, ETFs pool money from many investors and put the money into a diversified portfolio of stocks, bonds or other assets. When investors buy shares, they receive an interest in that investment pool.
But unlike index funds, ETFs do not sell shares directly to investors or redeem them on demand. Instead, ETF shares are traded throughout the day on stock exchanges at market prices.
How to Invest in Index Funds: Step by Step Guide
1. Have a goal for your index funds
Before you start the topic of how to invest in index funds, it’s important to know what you want your money to do for you. If you’re looking to cash out quick in a matter of years or even months then you should be better off going for individual stocks or even cryptocurrency. Of course, you know that also means you are ready to take lots of risks.
But if you’re looking to let your money grow slowly over time, then index funds may be a great investment for you. If you also know someone who wants to invest for retirement you can as well recommend this.
So the first step on how to invest in index funds is to set a goal.
2. Open An Investment Account
The second thing on your to-do-list about how to invest in index funds is to open an investment account. Yes, once you are clear on your investment goal and see that it aligns with how index funds work, the next thing you need to do is to open an investment account.
Yes, you’ll need an investment account to buy index funds. The type of investment account you open depends on the type of goal you set in step one above. So here are the popular investment goals you could fall into:
Standard Brokerage Accounts
Taxable brokerage accounts or non-retirement accounts are a great way to build wealth. It provides access to a broad range of investments, including stocks, mutual funds, bonds, exchange-traded funds and more. But as the name suggests you may owe taxes on any income, like dividends or profitable asset sales. Taxable accounts are therefore the best for financial goals other than retirement. They’re also a good choice when you’ve already maxed out your retirement contributions for the year.
Retirement accounts like a 401(k) provide tax benefits to help you save for retirement. These accounts are best for long-term investing. In fact, it is important to know that withdrawals from a retirement account before retirement could incur penalties and taxes.
This account is specifically for funding of the education expenses of beneficiaries. And one of the most popular types of accounts used to pay for education expenses is the 529 savings plan. Most states offer their own 529 plans that you can open directly. But typically the money can be used at eligible schools nationwide. Relative or not, anyone can contribute to these plans on behalf of a beneficiary. And anyone can be named a beneficiary on the account, as long as the money is used for qualified education expenses.
Investment Accounts for Kids
This type of account gives you the chance to invest on behalf of a child. Cash and investment assets in the account become the child’s property when they reach a designated age. Usually the age is set to 18 to 25, depending on the state the account is held in. A good example of Children account is Custodial accounts, also known as UTMA/UGMA accounts.
3. Research Your Index Funds
It’s important to understand exactly what you’re getting into when you consider how to invest in index funds. So it is important that you do thorough research.
And the research process should start with choosing an index or a couple of index. The S&P 500 is probably the most well-known index, but there are also indexes based on company size, business sector and market opportunity, such as emerging markets.
Equity indexes are generally well suited to adding growth potential (and risk) to your portfolio. And the more niche your equity index, generally the more risk you’re taking on. Bond-based indexes add stability to investment portfolios and more modest returns.
Indexes to start your search with include:
- Broad market indexes like the Dow Jones Industrial Average (DJIA), S&P 500 Index, NASDAQ and Wilshire 5000 Index. Funds tracking one of these core indexes are commonly chosen by those looking to construct simple two- or three-fund portfolios.
- Equity indexes that group companies by size like the Russell 3000 Index (large-cap companies), Russell 2000 Index (small-cap companies) and S&P 400 Index (mid-cap companies). Generally, the smaller the companies in an index, the more risk and growth potential you take on.
- Indexes offering exposure to stocks from companies outside of the U.S., like the MSCI Indexes. Usually, the less developed a country’s economy, the more risk and growth potential you take on.
- Indexes based in the bond and fixed income markets, such as the Barclays Capital Aggregate Bond Index. Indexes with corporate bonds typically offer higher returns (and more risk) than those that only invest in government bonds.
Once you’ve settled on an index or indexes, you’re ready to research individual funds.
Things to Consider While Comparing Index Funds
- Expense Ratio. This is the cost to administer the fund each year. All things being equal, index funds based on the same index all track the same thing, so expense ratio can be a big deciding factor. If one fund charged 0.19% and another charged 0.03%, you’d save $16 a year per $10,000 you invested by going with the lower cost fund.
- Other Fees. You can generally avoid trading fees on index funds at most major brokerages, but be sure to look out for loads, or special fees charged by certain mutual funds when you buy or sell them. You should be able to find index funds for any index without load fees at most major brokerages, so don’t opt for a fund with loads just because it’s the first you’ve found.
- Investment Minimums. If you don’t have the cash to meet the minimum investment required, you can cross that fund off your list. If you really want to buy into that particular index, you should look for the exchange-traded fund (ETF) version of that fund, which will typically have no minimum beyond the price of one share.
Keep in mind that index funds tracking the same index at different companies will have virtually identical holdings, so expenses should be your primary focus.
That means you’ll want to pay attention to expense ratios, trading fees and loads. You’ll probably want to choose the index funds offered in-house by your brokerage of choice to minimize fees.
4. Buy the Index Funds
Now you are ready to buy your preferred index funds. Once you have a brokerage account, you can buy shares of the index funds you’ve settled on. Generally, you’ll search for or type in the ticker symbol of the fund you want to purchase and the dollar amount you want to invest.
You’ll need to buy enough to reach the fund’s investment minimum. But after you do, you can typically buy fractional shares going forward. The site may ask for your preference regarding dividends. That is, whether they should be used to purchase additional fund shares or deposited into your account as cash.
If you’re reinvesting for the long term, most experts recommend you reinvest your dividends. This is because historically dividends have been responsible for substantial investment growth.
5. Set Up Your Purchase Plan
Still on how to invest in index funds. Yes, you are not done just yet even though you have invested. Ideally, investing shouldn’t be a one-off exercise. It should be an ongoing practice. So you’ll need to think about your plan for buying index funds over time. Financial advisors often recommend dollar-cost averaging. This is a practice of putting a certain amount of money into your investments at set intervals.
According to Erika Safran, a CFP in New York City, “The beauty of dollar cost averaging is that investors add to their portfolio in high and low markets, eliminating the emotional push to buy high and sell low,”
To make this happen, set up automatic investments that happen on a schedule with your brokerage. You can decide to set it on a monthly basis or every payday. This ensures that you’ll continue to invest on a regular schedule.
In general, investing is about the long game: Although the stock market has its short-term ups and downs, over your investing life, buying and holding a diverse investment mix historically results in successful returns.
For best results, review your portfolio every six to 12 months and rebalance when your investments have drifted too far from your original allocation. To rebalance, you’ll sell some of the categories that have gotten too large and buy more of the category that’s gotten too small. This helps keep your portfolio on track to reach your goals.
6. Decide on Your Exit Strategy
Finally on how to invest successfully in index funds, you need an exit strategy. Yes, investing is like a business, so it is important you have an exit plan or strategy even before you start.
Although buying and holding is a solid investment strategy on its own, yet, you should also think about when and how you’ll sell your shares.
If you’re investing in a taxable account, you’ll have to consider capital gains taxes and whether you can offset gains with losses in other investments through a process called tax-loss harvesting. If you’re in a tax-advantaged retirement account, you’ll want to brainstorm ways to minimize the taxable income you earn each year through retirement account withdrawals.
A financial advisor or tax professional can help you figure out the best strategies for managing withdrawals from any type of investment account.