Index funds are getting popular now because they are easy to understand, don’t cost much, and provide stable returns over time.
As per the CNBC report, in 2019, index funds held $4.27 trillion in assets, compared to $4.25 trillion in active funds.
Index funds are getting more popular even competing with the active funds for total asset value. Index funds are easy to understand that simply follow a particular financial market index like Standard & Poor’s 500 Index.
The goal of index funds is to keep the returns up with the following index, not to beat the market like the case with equity mutual funds.
Fund managers are not required to pick the individual funds so index funds bear a low expense ratio. This is also one of the reasons behind getting more popular for retail investors.
In this article, I have explained a step by step guide on how to invest in index funds as a beginner.
You will learn
- What is Index Fund
- How to Invest in Index Funds (A Step by Step Guide)
- Benefits of Index funds
- FAQs about investing in Index Funds.
What is the Index Fund?
Index funds follow their benchmark index portfolio and perform similarly. Just an example, when an index fund tracks a benchmark like the Standard & Poor’s 500 Index, its portfolio will have the 500 stocks that comprise S&P 500, in the same proportions.
That is the reason for the same performance as the index. If S&P 500 Index grows 10% annually, your SP&500 index fund will give you a return close to the index performance.
The overall index fund gives you positive returns but doesn’t outperform the index, unlike equity mutual funds that exceed the index over time.
However, if there’s a big market crash, when index dipped all-time low, the index fund will also follow the index and give you negative returns.
Still, an index fund has low risk as compared to other funds because the whole index drops very less as compared to a single stock.
You can use Index funds to balance the risk in your investment portfolio because the whole market trend tends to be less volatile as compared to individual stocks.
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Step by Step Guide to Invest in Index Funds
#1. Set Your Investment Goal
Setting your investment goal will help you select the index fund that suits your needs.
You need to decide your investment tenures like whether you want to invest for the long term or short term. Based on your goal, you can choose the index funds asset class.
Your investment goal can also be based on your expected return. Higher return investment assets carry higher risk as well.
There are 2 categories for index funds.
1. Equity-oriented index funds
If you have long-term investment plans, then you can go with aggressive equity-oriented index funds. Because you can afford to take more risk by investing in stock-based index funds that will yield higher returns.
2. Bond-oriented funds
If you want to invest for the short term like 1 or 2 years, then you can go with a bond-based index fund. You would prefer to invest in safer instruments for stable returns and avoid market volatility.
You can choose an index fund category depending on your investment timeline.
|High Risk – Longer Timeline||75% equities and 25% bonds|
|Moderate Risk – Moderate Timeline||50-60% equities and 40-50% bonds|
|Low Risk – Short Timeline||25% equities and 75% bonds|
#2. Research the Index Fund
You should start your research with the types of indices you like to invest in. When you follow any index, you should consider the risk factor in mind.
Indices like S&P 500 or Dow Jones track the stocks that make them high-risk-oriented indices.
But indices like Bloomberg Barclays U.S. Aggregate Bond Index are low-risk indices that track government securities with fixed returns.
We have categorized indices in 2 categories based on the risk factor –
- Aggressive Risk
- Conservative Risk
Once you have decided which index you want to go with, you need to track the funds that track your selected market index.
#1. Aggressive Risk (Long term investment)
You can go with equity-oriented index funds that follow the S&P 500 or NASDAQ 1000 if you want to invest for the long term.
For example, Vanguard S&P 500 Index Fund or Fidelity Nasdaq Composite Index Fund.
You may also opt for the small-cap index funds that track the Russell 2000 or S&P 600. Small-cap index funds might perform better than large-cap index funds but also carry higher risk value than any other index fund.
#2. Conservative Risk (Short term investment)
You can look for bond index funds that mimic the Bloomberg Barclays U.S. Aggregate Bond Index. For example, Fidelity® U.S. Bond Index Fund.
You can also track funds that track the debt issued by the federal government such as Bloomberg Barclays U.S. Long Treasury Bond Index.
You can shortlist Top-3 funds in both categories that will help you at the time of investment.
You can start your index fund research online through platforms such as Morningstar, a fund rating agency such as S&P Ratings, or online brokerage portals such as Charles Schwab.
#3. Open Investment Account
You need an investment account to start investing in the index funds.
You can invest in index funds through several account types –
- Retirement accounts, such as an IRA, Roth IRA, or 401(k)
- Personal brokerage accounts
Ideally, you should first max out tax-advantaged accounts such as Roth IRA or 401(K). Then deposit additional funds for investing in Index Funds or any other investment asset.
You can open an account with a stockbroker to start investing in IRAs and index funds as well.
Look for a broker that offers you low account-related fees such as transaction fees and low per trade charges. Some reputable brokers like Vanguard or Schwab provide excellent service at a low cost.
Steps to open an investment account
- Finalize Stockbroker – Search and compare the stock broker’s brokerage, services such as trading platform, stock research, fractional share investment, funds transfer facility like EFT (Electronic fund transfer), wire transfer and asset transfer, minimum initial deposit
- Online Application – Fill the application form carefully. You need to provide your social security number and driver’s license number. You will have to fill details about your employment status, net worth and investment goals.
- Deposit Funds – Deposit the amount you want to invest or you can initially deposit the minimum amount required and later on transfer the remaining funds.
- Start investing.
#4. Invest in the Index Fund
Once your investment account is opened, you can start investing in your shortlisted index funds.
You can invest in multiple index funds depending on your investment goals or available funds available. Ideally, investing in a total of 2 to 4 index funds is sufficient.
For example, you can start one bond-oriented and one equity-oriented index fund to cater to different needs.
Like, bond-oriented funds could be for a short-term goal like your next vacation and equity-oriented funds could be additional savings too early retirement funds that would serve the long-term purpose.
Steps to invest in an index fund
#1. Decide the platform
You can invest either through your investment account or you can buy directly from a mutual fund company. However, mutual funds companies charge high commissions, so if you already have a low brokerage investment account, then stick with that.
List of stockbrokers with $0 account minimums and low commissions –
- J P Morgan
- Charles Schwab
#2. Select Index
Decide which market index you want to track like S&P500 or Nasdaq.
#3. Select index fund
Finalize which index funds you want to invest in. You can choose the fund based upon your investment budget, risk appetite, investment goals.
Also compare the expense ratio to go with low-cost funds. Pay the money.
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#5. Set a Maintenance Strategy
You should invest in index funds on monthly basis and rebalance your portfolio every year.
Rebalance is restoring the portfolio to make a balance between different asset types. In index funds, you can buy or sell index funds to make sure your equity and bond-oriented funds give you optimum returns in the next year.
Rebalancing the portfolio is crucial especially if you are investing in multiple index funds.
Because your diversification dissolves when you become heavily invested in one type of investment.
Means if you invest in only equity oriented funds, and stock market crashes, you will have negative returns and if you are more inclined towrds bond oriented funds, you might not get the expected returns.
So the best way is rebalance your portfolio for better future returns.
For example, your fund has a 70% equity ratio but those stocks may fall and your bonds may rise. You will have to rebalance your portfolio to get better returns from your index funds.
Check out – Charles Schwab vs Vanguard
Benefits of Index Fund in Investment Portfolio
#1. Easy to Understand
Index funds are easy to understand as they follow the same investment portfolio of their benchmark index. So, you can expect similar performance as of the benchmark index.
You can see the Nasdaq Index.
The index funds that benchmark Nasdaq Index would perform in the similar pattern as shown in the picture.
#2. Secure Investment
Since they mimic the index they are tethered with, they tend to be more secure as compared to other equity-based funds.
Because in other mutual funds the individual stock or majorly sector’s performance matters a lot on the overall performance of that fund.
The index funds depend on the market indices. If the market index falls, the fund may give you negative returns and if the market index rises, the fund will behave similarly.
But market indices fall for the short term but grow in the long term. That makes index funds more secure.
For example, in March 2020, the global markets crashed. S&P 500 index dropped by 12% and fell down below 2,500.
But if you check now, the S&P 500 has rallied again and currently its going above 4,000.
On the other hand, some equity based mutual funds has shown poor performance than the S&P 500 index. Let’s check 5 worst performing equity mutual funds that had lower returns than S&P 500 index.
#3. Diversify Your Portfolio
Since you invest in the broader spectrum, your money is invested in all the stocks that an index covers making it a safer investment option. Because a couple of stocks may underperform but the whole sector will still give you decent returns.
Index funds often invest in hundreds (a few in thousands) of holdings, while other funds generally invest in less than 50 holdings.
So the funds with a large number of holdings have relatively lower market risk than funds with lesser holdings.
#4. Less Expensive
Since the index fund portfolio follows the index only, the fund managers don’t need to actively manage the fund.
As the index fund requires less intervention from managers, there is less cost involved to manage the funds.
You can compare the expense ratio of index funds with other mutual funds.
For example- Schwab’s S&P 500 index fund has an expense ratio of 0.02% whereas the JPMorgan Small Cap Value R5 fund has an expense ratio of 0.87%.
#5. Steady Returns
As per Standard & Poor’s research, only 23% of actively managed funds outperform the index in 5 years.
Individual stocks may outperform or underperform the market but the market value surely increases over time.
If you check out the history of the S & P 500, the index has given an average return of 10% per annum for the last 90 years.
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If you are a beginner, you can start investing in index funds that would give you good returns over time similar to the benchmarking index.
Follow the above-discussed steps to have a clear understanding of your investment goal and how to achieve it.
Before summing up, we would like to share with you some important factors that you must consider below when researching index funds –
- Look for a low expense ratio among the funds
- Choose a Broker that offers a minimum initial investment amount
- Low brokerage fees
- No sales fees aka load fees. Some brokers offer no-load fees
Start investing any time, it’s never too late.
#1. Are index funds mutual funds?
Yes. Index funds are mutual funds that track the market index. Index funds are ideal for you if you want to invest in the safer types of mutual funds.
Index funds are not actively managed by fund managers thus offering a low expense ratio.
#2. Can I buy index funds on Robinhood?
No. Robinhood Financial LLC doesn’t offer mutual funds investments.
#3. Can index funds make you rich?
If you invest for the long term in equity-oriented index funds and rebalance every year, then you can expect wealth creation through your index funds.
Because over time the market index grows.
#4. Can index funds pay dividends?
Yes, most of the index funds pay dividends to the investors.
#5. Should you diversify index funds?
Yes, you should diversify your index funds to reduce market risk and you can also diversify your index funds based on your short-term and long-term goals.
#6. Where buy index funds?
You can buy index funds from your investment account like Vanguard or a broker like Alley that offers mutual funds investments.
#7. Which index funds track the Nasdaq?
Several index funds track Nasdaq. For example, Fidelity Nasdaq Composite Index Fund.