Index fund investing offers several advantages that make it ideal for beginners. They typically have low fees, require minimal maintenance, and offer built-in diversification. Often, a straightforward portfolio consisting of just two or three index funds can provide sufficient diversification for most investors.

Index funds are usually passively managed, meaning they aim to replicate the performance of an index, such as the S&P 500, rather than being actively managed by a fund manager.

However, index funds do have some drawbacks. The primary trade-off is the reduced control over the specific investments in your portfolio. Additionally, they may not always be as diversified as one might expect.

Despite these limitations, index funds are a great option for new investors or those who prefer a hands-off approach to managing their portfolios. In the following sections, we’ll guide you through selecting and purchasing the best index funds to maximize their benefits.

What is an index fund?

An index fund, whether a mutual fund or an exchange-traded fund (ETF), aims to replicate the performance of a specific index. For example, an S&P 500 index fund will closely track the performance of the S&P 500 Index.

While the S&P 500 and the Dow Jones Industrial Average are well-known U.S. stock indices, there are many other types, including international stock and bond indices. Investors often use a mix of index funds to diversify their portfolios.

If you’re participating in an employer-sponsored retirement plan, you might have access to index funds through mutual funds. However, if you’re interested in ETFs, you’ll likely need to invest independently. This typically involves opening a brokerage account, which offers benefits such as no minimum investment requirements and the option to purchase fractional shares.

How to buy index funds in 3 steps

Buying index funds is straightforward and easy. With the help of online brokers, you can begin investing quickly, often within just a few minutes.

1. Choose a broker

Your first step is to choose where to invest your money. You can either open an account with the broker that offers the specific fund you want or simply use your preferred broker. Many major brokers offer their own index funds, which generally track major indices similarly, so performance across brokers tends to be consistent.

However, there are differences between brokers that might influence your choice. For instance, Vanguard is investor-owned, which appeals to some investors. Fidelity is known for its user-friendly website, while TD Ameritrade offers advanced trading tools. Selecting the right broker depends on what features matter most to you.

Regardless of your choice, opening an account with an online broker will give you access to a wide range of index funds. You can choose between a brokerage account or a retirement account, such as an individual retirement account (IRA).

2. Pick your index fund(s)

The next step is to choose which fund or funds will receive your investment. Some popular options include:

  • Large-cap U.S. stocks: Vanguard S&P 500 ETF (VOO), iShares Russell 1000 ETF (IWB), Invesco QQQ Trust (QQQ)
  • Small-cap U.S. stocks: iShares Core S&P Small-Cap ETF (IJR), iShares Russell 2000 ETF (IWM)
  • U.S. total stock market: Vanguard Total Stock Market Index (VTSAX), Schwab Total Stock Market Index (SWTSX), iShares Russell 3000 ETF (IWV)
  • Total international stock market: Fidelity International Index Fund (FSPSX), Schwab International Index Fund (SWISX)
  • Total U.S. bond market: Fidelity U.S. Bond Index (FXNAX), Vanguard Total Bond Market Index (VBTLX)
  • Total international bond market: SPDR Bloomberg International Treasury Bond ETF (BWX), Invesco International Corporate Bond ETF (PICB)

Most experienced investors might avoid investing in both the S&P 500 and U.S. Total Stock Market funds since the latter includes the former. The S&P 500 represents about 500 of the largest U.S. publicly traded companies, while a total stock market index tracks all U.S. publicly traded companies.

Ultimately, how you allocate your money is a personal decision based on your financial goals and preferences.

3. Buy shares of an index fund

Once you’ve selected your broker and chosen your fund(s), the main work is complete; now you just need to purchase your shares. If you’re investing in multiple funds, you’ll also need to decide how much to allocate to each type.

Generally, younger investors who are saving for retirement might allocate a larger portion of their portfolio to higher-risk investments like stocks, benefiting from their longer time horizon before needing to access the funds. As retirement approaches, it may be wise to shift a greater portion of your investments into bonds or other lower-risk assets to minimize short-term volatility and preserve your capital.

Advantages and disadvantages of index funds

Index funds are a great choice for new investors, offering several advantages and some drawbacks to consider.

Advantages of index funds

  • Low Fees: Index funds track an index without active management, which keeps fees minimal. Some index funds even have no fees at all.
  • Built-in Diversification: Index funds that track broad indices, like the S&P 500, provide instant diversification by investing in a wide range of companies across various industries.
  • Minimal Maintenance: Index funds generally require less rebalancing. The fund itself manages the allocation of stocks within the index, reducing the need for frequent portfolio adjustments.
  • Tax Efficiency: Because index funds trade infrequently, they generate fewer capital gains, which can help lower your tax burden.

Disadvantages of index funds

  • No Stock Selection: Index funds automatically include all stocks in their index, so you can’t select individual stocks, which some advanced investors prefer.
  • Potential Lack of Diversity: Index funds are often market-cap-weighted, meaning they allocate more money to larger companies. This can lead to less diversity than anticipated, with larger companies dominating the fund.

In Conclusion

Index funds offer numerous advantages, such as low fees, minimal maintenance, and built-in diversification. Getting started is straightforward with an online broker, and a few well-chosen funds can help you build a solid portfolio. While index fund investing may lack the thrill of day trading, it’s a straightforward and effective way to enter the market. As legendary investor Warren Buffett puts it, “Index investing is the way to go for most people.”