Over the years, the term “index fund” has become a bit of a buzzword – and rightfully so – but many people still have questions about what index funds actually are.
The short answer is that they’re a type of mutual fund or ETF whose portfolio is designed to mirror a market index (like Dow Jones, S&P 500 or Nasdaq Composite). Of course, if you’re not already finance-savvy, that may sound like a lot of nonsensical jargon.
As an example, let’s say an index fund is based on the S&P 500. The S&P 500 measures the stock performance of 500 of the largest companies that are publicly traded in the United States. This hypothetical index fund would then possess stocks for all the companies in the S&P 500, in an attempt to mirror their overall performance. Since an index fund isn’t actively trying to determine which companies will have their stocks decrease and which will have theirs increase, they don’t need to be as actively managed.
Consequently, index funds will generally have much lower fees than those that ARE actively managed. However, most index funds have high commission rates, so if you intend to actively trade they may not be for you – they’re much better suited for buying and holding.
So, What Does This Mean For You, An Average Investor?
Well, if you don’t have time to monitor dozens of stocks (if not more), or don’t have the know-how, this gives you a much easier “in” to get started making profitable long-term investments. Index funds are simplified and a much more passive approach to investing than most. Also, in my opinion, anything that helps free up more of your time to focus on your personal life and bringing in extra income is a boon.
In addition to all of that, index funds are by nature a diversified investment, which can help mitigate risk (don’t forget – you can always invest in multiple index funds for even more diversification).
The Pros
- Spend less time managing your investments
- Generally, less risky than most investments
- Huge variety of index funds
- Lower fees than many other types of investments
- Potential tax advantages
The Cons
- You won’t beat the market, as the purpose is to match the market – however, few people are able to even match the market when they manage investments actively
- You aren’t able to pick stocks from the companies you like or avoid buying stocks from ones you don’t – a noteworthy issue if you are concerned with the ethical practices of certain companies
Here Is A Quick Guide If You Want To Start Investing In Index Funds
1. Open An Account With A Brokerage
I personally recommend going with a strong brokerage with tons of different index funds, like M1 Finance.
Which brings me to another thing to be aware of – different brokers may have completely different funds available to them, so before you choose make sure you check out the list of funds they provide. Also, if you want to invest in more than just index funds be sure the broker you choose offers other options as well. Before committing, check their fees and see if they’re competitive – at the time of writing this article most competitive index fund fees (expense ratios) are below 0.2% and many are below 0.1%.
2. Pick An Index Fund
While index funds based on the S&P 500 are generally recommended and in great supply, there are many options to consider.
There are funds based on company size, foreign vs domestic, specific industries, types of assets (bonds, commodities, etc.), and even emerging markets. Just remember, if you invest in a specialized index fund you may want to diversify in a few others as well in order to mitigate risk.
3. Double-Check Costs And Minimums
Even though index funds require less overhead than actively managed funds, a broker’s administrative costs can still be high. The two costs to pay attention to are expense ratios and minimum investment amounts.
I’ve mentioned competitive expense ratios, and this is the amount that will be deducted from your returns in order to cover the overhead of managing the fund. While these may seem low, they can eat away at your profits over an extended period.
Most funds will also have an investment minimum, which is just the minimum amount required in order to open an account. I’ve seen these vary wildly, but I would recommend expecting to invest at least $1000 USD when opening up a new account. If you find a fund that you can’t meet the minimum investment for, you’ll need to decide if there is another option that may be a better fit until you can afford it.
4. Automate Deposits
If this is your 401(k) you may already be doing this, however if this is a separate account I recommend setting aside a portion of your paycheck each month to go to it and setting up automatic withdrawals. By doing that, you’ll see a lot more growth over the years than if you had just left it alone after the initial deposit.
Conclusion
I’m a fan of index funds, especially for new investors and those looking for more passive investments. I’ve personally had great results but can understand how it may not be the ONLY solution for everyone (some people prefer to invest in more active methods or in physical assets like real estate and gold). If you’re interested in a more detailed guide on how to start investing, I wrote a follow-up article. As always, be sure what you invest in and how much you invest lines up with your long-term financial goals.
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