Right now, you’re in the process of planning your overall investment strategy and building a robust personal finance portfolio. You’re considering purchasing index mutual funds — a great strategy for both new and seasoned investors alike.
This post will provide a comprehensive overview of index funds, giving you everything that you need to learn to decide whether it’s time to start investing in them.
What Is an Index Fund? A Beginner’s Guide
An index fund is a type of exchange-traded fund (ETF) or mutual fund that is designed to track specific financial market indexes like the total stock market, the S&P 500 index fund, the Nasdaq composite, or the Wilshire 5000 Total Market Index, among others.
Index funds can also be broken down into specific sectors like technology, healthcare, government, and finance.
Why Should I Use Index Funds?
There are many reasons new investors should look into using index funds, which we’ll briefly explore next.
One of the top risks of entering the stock market is its volatility. It’s just about impossible to predict the performance of the stock market from year to year — and even quarter to quarter. This is something that professional investors struggle with as they try to “beat” the market.
“A low-cost index fund is the most sensible equity investment for the great majority of investors,” explains famous investor Warren Buffett in John Bogle’s book “The Little Book of Common Sense Investing”. “By periodically investing in an index fund, the know-nothing investor can actually out-perform most investment professionals.”
Diversify Your Investment Portfolio
In addition to minimizing risk, you can also gain access to a vast amount of market exposure to help diversify your portfolio — much more than if you were to buy individual stocks.
Plus, index funds are typically designed to rebalance periodically. In other words, funds have requirements governing which companies are allowed to remain in the portfolio (e.g., large-cap stocks like Amazon or small-cap stocks).
This is great for investors because it’s a way of automatically reshuffling your investments without having to track any securities, sell off stock, and pay capital gains taxes.
Achieve Long-Term Growth
If you think of the tortoise and the hare, index funds are like the tortoise — poised for slow, steady growth over time.
To assess whether an index fund is a good investment, look at its long-term history, stretching back to when the account first opened.
You’ll notice that strong index funds generally rise steadily over time, despite going through periodic losses. And be sure to compare them to broader investing benchmarks so you can determine how they measure up in both up markets and down.
Actively Managed vs. Passive Funds: Know the Difference
Index funds can either be actively or passively managed.
In an active fund, a fund manager builds an investment product by pulling a list of companies from a certain index and then modifying it to improve performance. The goal of an actively managed index fund is to beat market performance, which is not easy to do.
In a passive fund, on the other hand, the portfolio tracks the performance of a group of investments that’s unchanged.
Most investors tend to choose passive funds simply because tracking the market usually yields better results than hand-picking securities. Plus, passive funds tend to come with lower expense ratios because you don’t have to pay an account manager to handle the investment.
In this light, it’s the best of both worlds. You get to spread your risk out and diversify your holdings without having to absorb a ton of trading costs.
Why Vanguard Funds Are Popular for Investors
One word of caution when purchasing index funds: Watch out for heavy fees.
One of the key metrics to watch out for when shopping for funds is an expense ratio, which demonstrates how much of your investment will go to the overall upkeep of the fund (e.g., management, maintenance, and more).
Most funds today offer an expense ratio hovering between 0.5% and 0.75%. However, some can be in the 1%-1.5% range, or even higher. As such, it’s important to do your due diligence before buying any fund to make sure you don’t end up with one that’s expensive to own.
The Vanguard 500 Index Fund Admiral Shares (VFIAX)
Vanguard offers a long list of investments. One of them being the Vanguard 500 Index Fund Admiral Shares, which you might want to check out.
“As the industry’s first index fund for individual investors, the 500 Index Fund is a low-cost way to gain diversified exposure to the U.S. equity market,” says Vanguard. “The fund offers exposure to 500 of the largest U.S. companies, which span many different industries and account for about three-fourths of the U.S. stock market’s value.”
As Vanguard explains, the fund does have some level of risk. However, it can still be considered a core equity or the central investment in a long-term investment portfolio.
According to Vanguard, the fund might be risky for some investors because of its full exposure to the stock market. But if you’re able to wrap your head around the risk, you can consider this large-cap index fund a core equity holding due to its diversification.
Of course, there are many different index funds out there. This is just one of them, which you can use to benchmark the performance of similar accounts. Here’s a list of some of the best Vanguard funds.
You can also look into the following alternatives:
How Index Funds Fit into Your Overall Portfolio
You’re probably wondering how many index funds you should buy and how they fit into your overall portfolio.
As a core equity, index funds should make up a sizable portion of your overall portfolio. They should serve to provide structure and balance for your larger portfolio — shielding you over the long term against market downturns. At the same time, this stability can also give you the comfort needed to let you invest in individual stocks, too.
Remember, index funds won’t get you rich overnight. But they can certainly get you rich over a period of several decades, or even before then. Their slow and steady growth make them ideal for young investors who are looking ahead 20 to 30 years down the road. Starting early with regular investments in strong and low-cost index funds is a great way to set yourself up for financial independence.
That said, most investors have anywhere from 20% to 30% in index funds on average. However, your situation could be much different. Consider working with a financial advisor who can tell you if you’re putting the right allocation of your assets into index funds.
Index Funds vs. ETFs
As you explore various index funds, you’ll also notice a type of investment called exchange-traded funds (ETFs).
ETFs are similar to index funds, except they are generally considered to be more flexible and convenient. ETFs are essentially bundles of securities that can be bought and sold similarly to the way you would purchase individual stocks from a brokerage account. Unlike stocks, index funds are priced at the end of the trading day.
Let’s say you are excited about the future of electric vehicles and you want to invest in the industry, but aren’t sure which companies will be the key players and which will never get out of the garage. You could investigate the ETFs dedicated to this technology, buying a basket of EV companies with one purchase and leaving it to the experts to pick the winners.
Index Funds vs. Mutual Funds
Another type of similar investment model is mutual funds, which are collections of securities. These investment vehicles tend to contain a portfolio that includes some of the largest companies.
The main difference between index funds and mutual funds is that index funds track structured indexes (like the S&P 500 and Dow Jones Industrial Average), while mutual funds track a changing rotation of securities, which are picked by an investment manager.
Ultimately, you can’t go wrong with the best index funds, mutual funds, or ETFs — especially if they have a low expense ratio. There is a lot of variation within each category, and all are relatively low risk because they provide broad and structured market diversity.
Most investors tend to spread a portion of their portfolio out over all three. In other words, it’s common to own a healthy mix of index funds, mutual funds, and ETFs.
Liquidating Index Funds
As an investor, you have the ability to liquidate — or redeem — index funds at any time.
Most funds keep fees cash on hand to cover investors when they liquidate. In some cases, you can receive returns as little as the following business day.
That said, investors are sometimes surprised to learn that index funds can come with heavy exit fees — all of which can eat into your return.
These fees are all described in the fund’s prospectus. As such, it’s very important to read them before buying. Otherwise, you could wind up losing a considerable amount when you sell them. Always read the fine print when investing.
How to Buy Index Funds
You can buy index funds just like you would any stock, mutual fund, or ETF — online, through a leading brokerage firm.
Using an Online Broker like Schwab, Fidelity, or E*TRADE
Once you’ve decided to buy funds, the first thing you need to do is find a broker. There are countless online brokers to choose from, and they can vary depending on their fee schedules, user offerings, and user experience.
Word to the wise: If you’re going to be investing, then you’re going to be spending a lot of time using online platforms. Make sure to find a platform that you enjoy using — and one that makes it easy for you to trade.
On that note, system availability and performance should not be underestimated. You want to partner with an organization that will be able to accommodate you whenever you go to buy or sell stocks. If the platform struggles at peak times, it may not be the best option. But only you can make this decision.
When comparing brokers, you might also want to consider total investment offerings, mobile trading options, the amount of research and education tools they provide, and the quality of their data visualization tools, among other features. Give some thought to what tools and features you plan to use and then find a brokerage that provides what you need.
Can you buy index funds in an IRA or 401k?
You can certainly buy index funds in an individual retirement account (IRA), Roth IRA, or 401k. In fact, index funds are great for a 401k because they are typically designed for long-term growth over the decades.
So, if you invest in index funds through a retirement account at a young age, you should be in great shape when it’s time to tap into your savings in your golden years.
Do index funds have a minimum investment?
Some index funds will carry a minimum investment, which can be sizable in some cases. The price tag for entry can range between $3,000 and $10,000.
Keep in mind that you shouldn’t associate higher fees with any performance guarantees. Depending on what you are looking for, it can be smarter to buy more shares of an account with a lower entry fee.
Only you and your financial advisor can make this decision. But definitely shop around and know your options before proceeding.
Does past performance matter with index funds?
Past performance absolutely matters when purchasing index funds. You want to make sure that a fund is growing over time, especially if you’re considering an active fund and paying more for human intervention.
For example, consider the SPDR S&P 500 ETF Trust. Back in 1995, this fund was valued at roughly $44 per share. Today, this fund is valued at $355 per share — a noteworthy increase.
Do I need a portfolio manager?
It’s not uncommon for young investors to hire portfolio managers or even robo-advisors to manage their accounts.
On one hand, portfolio managers and robo-advisors can provide guidance and support and help you make the right account decisions.
On the other, some can charge exorbitant fees without improving the overall performance of the fund. In fact, some managers can actually make things worse by making poor decisions.
Add it all up, and you need to spend some time thinking about whether you need guidance before making a decision. Just remember that every dollar you pay in fees is a dollar that you’re not investing. Plus, index funds take out much of the guesswork, so there’s even less urgency to pay someone for guidance.
What is asset allocation?
Asset allocation is another way of describing portfolio diversification. It refers to the process of spreading your investments strategically in order to manage risk and maximize performance.
There are many different ways to allocate your assets across a portfolio. Some investors choose to take a conservative approach while others tend to be more aggressive.
Ultimately, there are no right and wrong answers about asset allocation. Rather, there are good and bad decisions that will determine your overall level of success.
Investing simply involves understanding what buttons you should press and when — and knowing when to hold off from making decisions entirely and simply let the market do the work for you.
What are real estate index funds?
More and more investors are starting to invest in real estate investment trusts (REITs) and ETFs as a way of investing in the real estate market without actually going through the hassles of home ownership or having to purchase a property on their own.
It’s possible to invest in individual index funds that track the overall success of the real estate market (like Vanguard Real Estate ETF, JPMorgan BetaBuilders MSCI US REIT ETF, and SPR Dow Jones REIT ETF).
The Bottom Line
Index funds are an excellent investment strategy regardless of your financial situation.
If you’re looking for reliable long-term growth that will give you strong protection against the volatility of the stock market, you should strongly consider looking into index funds.
Remember: The trick to the stock market is to get rich slowly. Don’t always shy away from risk. Instead, support it with strong and reliable funds that will yield strong gains over time. That’s the ticket to putting together a portfolio that leads to financial freedom.