How to Invest in Index Funds

An investment known as an index fund follows a market index, which is typically composed of equities or bonds. Typically, index funds invest in every element that makes up the index they follow, and they have fund managers whose job it is to ensure that the index fund performs identically to the index.

1. Pick the index that you want to track.
2. Choose a fund that tracks your selected index.
3. Buy shares of that index fund.

1. Pick an index

With the use of index funds, you can follow countless different indices. The S&P 500 Index, which comprises 500 of the best businesses on the American stock market, is the most well-known index. The following is a succinct summary of several additional major indices, organized according to the market segment they cover:

• 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

In addition to these broad indexes, there are other sector and country indices that focus on stocks in particular industries, style indices that highlight fast-growing businesses or undervalued stocks, and other indices that restrict investing based on their own filtering mechanisms.

2. Choose the right fund for your index

You can typically locate at least one index fund that follows the index you’ve picked. You may have a dozen or more options for tracking well-known indices like the S&P 500.

3. Buy index fund shares

To purchase and sell shares of the index fund you’re interested in, you can open a brokerage account. As an alternative, you can typically open an account with the mutual fund provider directly.

Again, it pays to consider costs and features when deciding which method is best for you to purchase shares of your index fund. It is less expensive to open a fund account directly through the index fund company because some brokers charge extra for their clients to purchase shares of index funds. Nonetheless, a lot of investors choose holding all of their interests in a single brokerage account. The brokerage option may be your best option to consolidate all of your investments into a single account if you plan to invest in a variety of different index funds offered by various fund managers.

Why invest in index funds?

Investing in index funds is one of the easiest and most effective ways for investors to build wealth. By 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 — and best of all, you don’t have to become a stock market expert to do it.

Investors find index funds especially useful for many reasons:

• Minimize your time spent researching individual stocks. Instead, 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 dozens or even hundreds of stocks and other investments, and the diversification leaves you less likely to suffer big losses if something bad happens to one or two companies in the index.
• Index funds are available for a wide variety of investments. You can buy stock index funds and bond index funds, which cover the two big parts of most people’s investment strategies. 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 usually far less costly than alternatives like actively managed funds. That’s 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. For instance, index funds don’t have to do as much buying and selling of their holdings as actively managed funds, and so index funds 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 automatically invest month after month and ignore short-term ups and downs, confident that you’ll share in the long-term growth of the market.

Why not invest in index funds?

As simple and easy as index funds are, they’re not for everyone. Some of the downsides of investing in index funds include the following:

• You’ll never beat the market. Index funds are designed solely to match the market’s performance, so if you want to prove your mettle as a superior investor, index funds won’t give you that chance.
• You don’t have any loss protection. Index funds track their markets in good times and bad, and 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’d rather not own, while missing out on others you’d prefer.

To address some of these shortcomings, you can always keep a mix of index funds and other investments to give you greater flexibility. If you plan on solely using index funds, however, you’ll have to get comfortable with their limitations.

4 index funds to get you started

If you’re looking for some index fund ideas to help you invest better, the following four are a good place to start.

• Vanguard 500 Index (VOO 1.42%): Tracks S&P 500 index; $4 annual cost for a $10,000 investment
• Vanguard Total Stock Market (NasdaqMutFund:VTSAX): Tracks index of U.S. stocks of all sizes; $4 annual cost for a $10,000 investment
• Vanguard Total International Stock Market (VXUS 0.95%): Tracks index of global stocks, excluding the U.S.; $11 annual cost for $10,000 investment
• Vanguard Total Bond (NasdaqMutFund:VBTLX): Tracks index of various bonds; $5 annual cost for a $10,000 investment