How to Invest in Index Funds

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For any investor, index funds can serve as a core holding, bringing diversity and stability to any portfolio. For new investors, index funds can serve as a simple entry point into a world that can often intimidate and overwhelm. While many individuals may have exposure to index funds via a company-sponsored retirement account or pension, most have never been taught how to invest in index funds on their own.

This article is a response to a Twitter community request. Friend of the site Flora posed the following regarding how to invest in index funds:

Flora Sunny(@florsunny)
Read a lot about people investing in index funds. Please, can you guide me to do the same? Thanks. Jan 4th. Tweet.

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Table of Contents

Why Index Funds Have a Place in Every Portfolio

Instant Diversification

For the average investor, diversification is key. While Warren Buffett famously said:

Diversification is protection against ignorance
Warren Buffett

Ignorance, when it comes to such a dynamic, diverse, and immense concept as the stock market, is not an insult. Staying on top of all the intricacies of a living market is out of the reach of most investors. Despite this, the majority can benefit from investing and see their fortune rise, partially supported by diversification.

Index funds based on a broad enough index allow investors to painlessly allocate their resources across a breath of stocks. Most index funds pull defining companies from across sectors, providing a solid, diversified base for any portfolio.

Lower Barrier of Entry

Diversification depends on the companies you invest in, but a general rule of thumb is that you can achieve it between 18 and 30 varied stocks. Buying even a single share across eighteen quality companies requires thousands of dollars, in addition to the hours of research necessary to identify a select group of diversified companies. Index funds leverage pooled resources to solve this issue. A share of a quality index fund can be had for a couple of hundred dollars, putting it within reach of millions of new investors.

Solid Consistent Returns

Index funds are designed to mirror the performance of the index they follow. While the performance of the companies included in the index may vary wildly, owning a piece of all of them has a smoothing effect, as the extreme performance of one is compensated for by others.

More of the profits generated by an index fund are returned to the investors, as passive management often dictates lower management fees. The makeup of an index is also slow to change, so there will be less buying and selling by the fund itself. Lower activity triggers fewer capital gains for the fund (taxable events charged back to the investors) than most actively managed funds.

Step One – Identify the Index You Wish to Follow

Index funds exist to mirror the returns of the index they follow. In the US alone, there are several indexes one might consider to either define or supplement your portfolio. The four broadest indexes to consider are:

Total market funds
S&P 500
- Basis- includes the 500 largest companies between the NYSE and NASDAQ
- Focus– Large companies. Currently this leads a large representation of Tech
- Weighting: Adjusted Market Cap
- Top Holdings: Apple, Microsoft, Amazon, Facebook, Tesla

Dow Jones
- Basis- includes only 30 of the largest US base companies
- Focus- Industrial
- Weighting: Price
- Top Holdings: 3M, American Express, Amgen, Apple, Boeing
NASDAQ
- Basis- includes stocks listed on the NASDAQ market
- Focus: Tech
- Weighting: Market Cap
- Top Holdings: Apple, Microsoft, Amazon, Facebook, Tesla

Additional Index funds exist based off of:

market cap (small, medium, large, mega)

*Many nano and micro-cap stocks are not eligible for inclusion in actively or passively managed funds.

Country, Geography, or Emerging Markets

specific industries (tech, defense, health, etc).

For new investors, a single index fund is a good start. An investment into a total market fund, or one following one of the three major US indexes (S&P 500, Dow, NASDAQ), can provide a solid basis for their portfolio.

Step Two – Decide on a Fund

If you already have a brokerage account and wish to keep your investments in one place, you may decide to start by reviewing your broker’s offerings. Core indexes will have a myriad of index funds created around them, and your current account is likely to provide access to a suitable fund. Some things to consider when deciding on the best fund for you:

Performance – While past results are no guarantee of future performance, some funds do a better job of mirroring the underlying index than others.
Minimum Investment– Many index funds do not have a minimum investment, but some larger ones do.
Expenses and Fees– While index funds are more or less passively managed, the majority still have associated expense ratios to cover their management fees.

Expense ratios often go overlooked, as a difference between a .02 and .2 can seem almost imperceptible. Over the years, these fees can have a notable impact, reducing the returns you worked so hard to achieve. Recently, some index funds have appeared with no expense ratios.

Step Three Decide Where to Purchase and Hold

Established investors may prefer to purchase index funds through their current accounts. For new investors, there are several reputable brokers to help you along the way.

I have personally used E*Trade for over a decade and have had no issues with our partnership. If you decide you are ready to open an account, use code cv095ms at sign-up to earn additional cash upon hitting key funding milestones within the first 60 days.

I have also assisted several friends and family members with their accounts at Fidelity, with no complaints regarding their service.

Consider Setting Up Automatic Investments

Consistent investing can be difficult. Whether setting aside the money among other expenses, underestimating the impact just a couple of hundred dollars can have over time, or a desire to time the market, it’s easy to let one’s investment strategy fall by the wayside.

Many brokers will allow you to set up automatic investments. You tell them the fund and the dollar amount you wish to invest on a consistent schedule, and your holdings will consistently grow over time.

Can You Lose Money Investing in Index Funds?

As with any investment, you can certainly lose money investing in index funds. Given a long enough time horizon, the board US market has been one of the most consistent generators of wealth in the world. Despite this, there will be weeks, months, and occasional years where the market will lose money. Do what you need to do in these times, but continue to invest what you can. Index funds can lose money, but if you can avoid panicking, history points to your wealth recovering in the years to come.

When to Buy Index Funds

The best time to invest in an index fund is at your earliest opportunity. ~~Since we can’t go back in time, the best time to start becomes now~~. Study after study has shown that investing your money at the earliest opportunity outperforms most active strategies. Much of this comes down to the power of compound interest, as the more time your money has to work for you and grow, the better you will be later in life. The worst thing you can do in many parts of life is to wait for a perfect moment that doesn’t exist.

Index Funds: a Smart Addition to Any Portofolio

Index funds are a strategic way for individuals without the time, inclination, or expertise to keep up with their holdings to benefit from the stock market. For dedicated investors, index funds can bring stability as a core holding in a larger portfolio. It’s not a secret that I invest in individual stocks. I enjoy it and have been fortunate enough to routinely outperform the market. I’ve invested thousands of hours and allocated far too much thought to a market that is often irrational. This past year, the three major US indexes outperformed my portfolio. If you are looking for a place to invest (not your emergency fund), you won’t regret a simple index fund.