Index funds have grown to be one of the single most popular investment vehicles in the United States. According to a 2019 report from Morningstar, half of all U.S. stock investments are in passive funds, such as index funds. The low cost and market-matching performance make them an attractive way to invest for beginners and experts alike. Here's a look at how to invest in index funds.
What Is an Index Fund?
Index funds are baskets of stocks that follow a specific market index. For example, popular index funds give you exposure to the same stocks as the S&P 500, Dow Jones Industrial Average, Russell 2000, and other indices. Each index tracks the performance of a specific group of investments, usually stocks, with a related theme or topic.
If you look at the history of index funds compared to actively managed funds, index funds tend to win about 80% of the time. It's also important to remember that the current situation is temporary. Historically, you are likely to get a better annual return if you invest in the stock market, then if you just let your money sit in the bank account, thanks to compound interest. Just remember to invest in the long-term and only invest money that you won't need for at least five years or longer.
Step #1: Pick a Brokerage and Open an Account
To buy an index fund, you need a brokerage account. Once your account is funded, you can buy and sell index funds like exchange-traded funds (ETFs) or mutual funds. Both give you access to the same underlying stocks and other assets. However, the way you buy and sell them works a little differently.
In the fall of 2019, most of the large discount brokerage firms dropped fees for trading ETFs. Some charge up to around $50 per trade for mutual funds, however. Here's a glance at where you may want to start.
Fidelity, Schwab, and Vanguard are arguably the best brokerages for mutual fund index funds. Each of these brokerages has its own family of mutual funds that you can trade with no fees. They may also offer a larger list of partner funds you can buy with no-load and no-transaction-fee. Do your best to avoid big fees for buying and selling funds.
For ETFs, you have a wider array of choices with no trade fee. In addition to Fidelity and Schwab, take a look at Ally Invest, Public, and E*TRADE. All offer no-fee trades for stocks and ETFs:
|Options Trades||$0/trade + $0.65/contract ($0.50/contract for 30+ trades/quarter)||$0.50/contract||N/A|
Also, you can check out our best brokerage list for an updated view of where to keep your cash and index funds.
Can you buy index funds with a robo-advisor?
Robo advisors are online investing platforms that use algorithms and mathematical rules to create and manage investment portfolios.
When a robo advisor builds a portfolio, it takes into account the investor's goals, risk tolerance, and time horizon. The robo advisor then determines the ideal asset allocation for your needs and makes sure it maintains that ideal balance.
Most robo advisors use index funds to achieve their goals. However, robo advisors may not be the best way for you to purchase index funds:
- You won't get much say in which index funds the robo advisor purchases. Robo-investing platforms are designed to be indeed “set it and forget it.” Although the robo advisor may allow you to pick which sectors you want your money invested in, you won't have as much control over your funds as if you used a stock broker.
- Most robo advisors charge annual fees. Since many brokers have eliminated commissions on trades, you'll save money by using a broker rather than a robo advisor.
Step #2: Pick your first index fund
If you're ready to get started, you need to pick your first index. While you may be tempted to buy one of the really big, popular S&P 500 funds they talk about in the news, it's a good idea to do your own research and choose the fund and index that make the most sense for you.
Investing in the S&P 500 is a popular starting place for good reason, however. This group of 500 of the largest stocks in the U.S. has provided a historical average return of around 10% per year over a long period. While there is undoubtedly volatility and past performance isn't a guarantee of the future, this is considered one of the safer, cheaper ways to invest.
S&P funds from places like Vanguard, Schwab, iShares, and Fidelity charge you less than 0.10% in annual fees. Thanks to cutthroat competition, a few have dropped below 0.05%. But bad ones can charge more than 2%, so look at that expense ratio before buying.
But that's just a starting point. There are many, many indices to choose from for future investments:
- Some are broad market like the S&P 500.
- Others focus on specific industries, company sizes, commodities, countries, regions, asset classes, and other criteria.
For more research, check out ETF and mutual fund screeners that allow you to sort through giant lists of funds quickly using criteria including expense ratios and other factors.
Step #3: Enter your trade
ETFs are similar to stock trading. You can buy shares of any ETF during market hours, often with no transaction fee, and have your order execute immediately. Mutual funds allow you to buy whole-dollar amounts and have all trades execute at the end of the market day.
There are pros and cons to each.
- For most people starting out, ETFs are easier.
- Mutual funds are excellent for long-term investing.
- Both ETFs and mutual funds have an annual fee, called an expense ratio.
- Sometimes ETF fees are lower, and sometimes mutual fund fees are lower. So take a look at a few options for each index before buying in.
Slow and Steady Wins the Investment Race
If your portfolio is exciting, it may be too risky. Index funds do have their own risks and should not make up 100% of everyone's portfolios. But they are popular for very good reasons. Adding a regular, consistent amount to your investments is called dollar-cost averaging. This is a solid strategy for building up an index portfolio from zero over time, even during a market downturn.
And if you can achieve market-level returns at rock bottom costs with instant portfolio diversification, why would you invest any other way?
Index funds are just one way you can diversify your investments, which is one of the surest ways to weather stock market volatility. For most, index funds should be a major part of your investment strategy.