Feb 5, 2023
How to Invest in Index Funds: A 3-Step Beginner’s Guide
An index fund is a type of investment that tracks a specific stock market index, like the S&P 500. By allowing you to invest in hundreds or thousands of stocks within a single fund, index funds offer an easy way to diversify your portfolio—and most are affordable, too.
An index is a group of stocks, bonds, and other investments that trade on the stock market. So, if you buy an S&P 500 index fund—an index fund that tracks the S&P 500 index— you’d be invested in every company listed on that index.
Index funds are great investments for beginners because they allow you to own a wide variety of stocks in one fund. This diversifies your portfolio and is less risky than investing in individual stocks.
If you’re just starting out on your investing journey, don’t fret—investing in index funds is a lot simpler than you might think. We’ll show you how to do it in three simple steps:
- 1. Choose an index
- 2. Research individual index funds
- 3. Buy your index funds
- FAQs about how to invest in index funds
Ready to learn how to start investing in index funds? Read on!
1. Choose an index
To invest in index funds, start by choosing the index you want your fund to track. An index is simply a list of securities that represent a subset of the entire stock market.
There are thousands of different indexes tracking just about every sector of the economy you can think of. While any given index may be structured based on various factors, they’re often characterized by capitalization and market sector.
You may have heard of one of the most well-known indexes, the S&P 500. It’s composed of the 500 largest U.S. companies traded on the New York Stock Exchange based on factors like profitability, market capitalization, and trading volume.
Other popular indexes include the Dow Jones Industrial Average (DJIA), a price-weighted index containing 30 of the leading companies in the U.S., and the tech-heavy Nasdaq Composite index.
Here’s a list of other popular indexes and what market segment they track:
- S&P 500: Capitalization-weighted index of 500 largest U.S. companies
- Dow Jones Industrial Average (DJIA): Price-weighted index of 30 blue-chip stocks across all U.S. industries except transportation and utility companies
- Nasdaq Composite: Capitalization-weighted, tech-heavy index of 3,000+ stocks traded on the Nasdaq stock exchange
- Wilshire 5000: Also known as the “total stock market index,” a comprehensive index of every publicly traded company in the U.S.
Reference your investment goals and risk tolerance to help you choose the right index for you. Broad market indexes like the DJIA or S&P 500 are great starting points if you’re new to investing, but you can tailor your choice according to the type of exposure you want for your portfolio and how much risk you’re willing to take on.
2. Research individual index funds
Once you’ve picked your index, it’s time to find a fund that tracks it. For most indexes, you’ll find a slew of associated funds available to choose from, so you’ll need to research your options. In general, this choice mainly comes down to cost.
To choose the right fund for you, keep these considerations in mind:
- Expense ratio: This is what you’ll pay in operating expenses each year. You want this to be as low as possible, ideally between 0.05% and 0.15%. For example, an expense ratio of 0.04% means you’ll only pay $0.40 per year for every $1,000 invested.
- How closely the index fund matches the performance of the underlying index: A well-managed index fund should closely mirror the performance of the index it’s tracking.
- Investment minimum: This is the minimum amount you’ll need to invest in an index fund. Some brokerages don’t offer index funds below a certain amount, so if you know you only have $200 to invest, cross off any funds with an investment minimum above that.
- Restrictions: Find out if there are any restrictions or requirements for any fund you’re considering and ensure you meet them.
To help you find low-cost index funds, start by comparing the expense ratios of the funds you’re considering. It’s one of the highest costs of an index fund, so look for the lowest expense ratio possible. Other costs to look out for include trading fees and loads.
Investor tip: An easy way to vet an index fund is to review its returns over the last year to see how closely it matches the performance of the underlying index. Ideally, it’s nearly identical—this usually means the fund is properly managed.
3. Buy your index funds
Understanding how to buy index funds is surprisingly easy once you’ve chosen the index funds you want to invest in.
When it comes to where to buy index funds, you can either go directly through a mutual fund company or open an online brokerage account. The best approach to deciding where to purchase an index fund is to select a provider that aligns with your investment needs and goals.
Suppose there’s a specific brokerage you know you want to purchase an index fund with, like Fidelity or Vanguard. In that case, you can open an account directly with them to avoid paying high transaction fees.
But if you think you’ll be investing in multiple index funds from different companies—for example, maybe you have your eye on both a Vanguard index fund and another index fund offered by Charles Schwab—a catch-all brokerage account that allows you to combine multiple investments in a single place is likely the better option.
Investor tip: If you want to invest in index funds to build long-term wealth, consider reinvesting your dividends when making your purchase. This help your investment grow and compound over time.
Pros and cons of investing in index funds
Investing in index funds is an excellent investing strategy for novice and seasoned investors alike, but like any investment, it’s important to consider their pros and cons.
It’s tough to understate the advantages of index funds. Here’s where they shine:
- Beginner-friendly: Index funds omit the need to research individual stocks, so no prior investment knowledge is required.
- Low risk: A single index fund can hold thousands of stocks from different companies. The low performance of one company in your fund can be offset by the high performance of others.
- Diversification: Index funds allow you to invest in thousands of companies instantly, providing built-in portfolio diversification.
- Low cost: Since they’re passively managed, index funds are cheaper than actively managed mutual funds.
- Allow you to automatically invest: You can set up dividend reinvestments to have your returns reinvested each month, helping you build long-term wealth.
While index funds have plenty of advantages, they’re not always the right investment for everyone. Here are some disadvantages of investing in index funds:
- Less portfolio customization: Index funds offer less control over which stocks and assets you own in your fund. Your index fund may include stocks you don’t want.
- Not immune to market turbulence: Index funds aim to mirror the market’s performance, whether the market is up or down. If the market takes a downturn, your index fund can, too.
- Not ideal for short-term investing goals: When you’re investing for the long term, index funds have enough time to bounce back from short-term market fluctuations. But if your time horizon is only 3–5 years, consider an alternative investment.
Investing in index funds is one of the most effective ways for investors to start building long-term wealth. They’re affordable, offer instant diversification, and let you own a wide array of stocks—all for less risk and within a single investment.
Now that you know exactly how to buy index funds, don’t wait to get started. Remember, building long-term wealth depends on investing regularly and consistently. The sooner you get started, the longer your money has to grow.
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FAQs about how to invest in index funds
Still have questions about how to buy an index fund? Find answers below.
Why invest in index funds?
Index funds have long been recommended to novice and seasoned investors alike because of their low cost, low risk, and built-in diversification.
Rather than paying top dollar for an actively managed mutual fund—which rarely succeeds in “beating the market”—index funds are a passive investment alternative that can bring steadier returns over time.
How much money do you need to invest in index funds?
It depends on the broker you decide to invest with. Many index funds have an investment minimum between $1,000 and $3,000, but some brokerages offer index funds with low-to-no minimum investments.
If you only have $100 to invest, you won’t be able to invest in most of Vanguard’s index funds because they have a minimum of $300.
What’s the difference between index funds and ETFs?
Index funds and ETFs are very similar, but the main difference is how investors trade them on the market. An ETF is a fund that trades like a stock, so you can buy and sell them during a regular trading day. Index funds can only be bought and sold at a price designated at the end of the trading day.
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