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Index funds are a type of mutual fund that aim to track the performance of a market index. Financial experts recommend index funds as the best investing vehicle for most people because they’re low-cost, low-risk choices for growing wealth. Here’s how you can get started investing in index funds.
1. Decide on Your Index Fund Investment Goals
Before you start investing in index funds, you’ll want to be clear about your goals, especially when you hope to accomplish them.
“A short time horizon indicates a lower ability to take risk, which would lead you to weight a bond index fund higher than if your time horizon were longer, which affords you the ability to take on more risk and to likely increase your stock allocation,” says Andrew Rosen, certified financial planner (CFP), president and partner at Diversified Lifelong Advisors LLC.
Remember, more aggressive investments—like equity index funds—offer greater potential returns in exchange for more risk. If you don’t have plenty of extra time to ride out market declines, you might be forced to withdraw your money and sell at a loss.
More conservative investments, like bond-based index funds, are better choices for near-term investing. They offer more stable value, but more modest returns. Alternatively, your goal is investing for retirement—a goal that may be decades in the future—stock index funds are a great way to boost your returns over the long term.
2. Pick the Right Index Fund Strategy for Your Timeline
Once you’ve settled on your goals and timelines, you can decide which index fund strategy gives you the best chance to reach your goals.
Setting your index fund investing strategy begins by choosing the right asset allocation, or the percentage of your portfolio comprising stocks versus bonds, based on your timeline. In addition, you need to evaluate your appetite for risk, regardless of how long you plan to stay invested.
If you can’t stand the prospect of losing any of your money, for example, you might opt for more conservative investments even for a distant goal. You’ll have to add more of your own money, instead of relying on investment growth, to reach your goal, but that compromise might be worth your peace of mind.
Here are some guidelines you can start with to tailor your index fund portfolio based on your risk preference and timeline, according to Steven Jablonski, a financial advisor at Informed Family Financial Services:
- Aggressive Risk/Longer Timeline: 75% equities and 25% bonds.
- Moderate Risk/Moderate Timeline: 50-60% equities and 40-50% bonds.
- Conservative Risk/Short Timeline: 25% equities and 75% bonds.
3. Research Potential Index Funds
Index funds take a lot of the burden off of investors by investing in hundreds—or even thousands—of different stocks and bonds. That means you don’t have to worry about picking any one winning stock and instead can benefit from the overall growth of the market or industry your fund is tracking.
That said, you’ll want to research which types of indexes you plan to invest in as well as individual funds that track them. Here are some indexes to consider based on the level of risk of you want to take on:
- Higher Risk. Broad, large-cap stock-based indexes like the S&P 500 or NASDAQ 1000. You may also consider small-cap indexes that track the Russell 2000 or S&P 600 and offer the chance to benefit from small companies’ greater potential for exponential growth. International indexes, like MSCI Emerging Markets and MSCI EAFE, can also fall into a higher risk category due to the more unpredictable nature of less established economies.
- Lower Risk. Look to bond indexes like the Bloomberg Barclays U.S. Aggregate Bond Index. For even lower risk, you may consider indexes that only track debt issued by the federal government, like the Bloomberg Barclays U.S. Long Treasury Bond Index or Bloomberg Barclays U.S. Treasury 1-3 Year Bond Index.
Though most funds tracking a particular index contain the same securities, each may have slightly different percentages of them, which can impact how well they mimic an index’s performance.
Keep an eye out for index fund fees, like loads and expense ratios. Sales loads are fees some funds charge just for buying or selling a mutual fund while expense ratios cover the costs associated with running a particular fund.
While you can largely avoid load fees by shopping around, you’ll likely be on the hook for some kind of expense ratio regardless of where you invest. Expense ratios can vary drastically even between virtually identical funds, so choose investments with histories of good performance and the lowest possible expense ratio.
Be sure to look for any investment minimums, too. Some index funds may require you to put in at least a few thousand dollars to start investing with them. After that minimum initial investment, you’re generally able to invest in whatever dollar amounts you want.
If you can’t find index funds whose minimum initial investment you’re able to reach, you might consider exchange-traded funds (ETFs) that track the same index but generally lack any investment thresholds.
You can start your index fund research online with tools made available through companies like Morningstar, a fund rating agency, or even the online brokerage you’re planning to use to invest in your index funds.
4. Open an Investment Account
If you don’t already have an investment account, you’ll need to open one before you can invest in an index fund. You can invest in index funds using a wide variety of account types built for different goals:
- Education savings accounts, such as a 529 plan
- Retirement accounts, such as an IRA, Roth IRA or 401(k)
- Taxable brokerage accounts for goals other than retirement
When choosing where to open an account, make sure you look for any sort of account-related fees. Will your brokerage of choice, for example, charge you each time you make a trade? If so, you might be better served finding a brokerage without these fees.
5. Purchase Your First Index Funds
Once your investment account is set up, you can fund the account and make your index fund purchase. Be sure to check any fund minimums and make sure you’re ready to invest at least that much.
Your broker will have you complete a trade ticket where you choose how your money is invested. For example, you’ll dictate whether you want to make the purchase at the market price, which is the current value the fund is trading at on the open market, or a limit price, which is usually a price lower than the current market price. If you place a limit order, your buy order won’t be executed until the fund’s value drops to or below your limit price.
Once your trade is completed, your money goes to work in the funds of your choice.
6. Set Up a Plan to Keep Investing Regularly
For most people, buying an index fund isn’t a one-time thing. Rather, it’s part of an ongoing strategy to save and build wealth for future goals. That means you need a plan to keep investing through a regular purchase plan.
A regular purchase plan has a few benefits for investors. First, you get to capture the power of dollar-cost averaging when you set up recurring purchases. Instead of trying to time the market, you’ll make regular investments that are agnostic of price. Over time this can decrease the cost you pay per index fund share as well as minimize the risk of buying shares at a high price. Regular, automated investing also has the benefit of making sure you never forget to save for your goals.
You’ll also want to set up an investment review schedule to assess your index funds’ performance. During these reviews, which are usually no more than once or twice a year, you can also rebalance your portfolio to make sure your asset allocation is still in check to help you reach your goals.
If you’d prefer not to worry about this routine maintenance, you might consider opening your accounts with a robo-advisor, which will manage and rebalance a portfolio of diversified, low-cost index funds for you. While convenient, robo-advisors do cost more than a DIY approach to index fund investing, even if this is still a fraction of a traditional financial advisor’s rate.
SoFi Automated Investing
SoFi Management Fee
On Sofi's Website
$3 to $5
On Acorn's Secure Website
Annual advisory fee
On WealthFront's Website
7. Consider Your Exit Strategy
No one holds onto an investment forever, so it’s smart to think about when you’ll sell your shares. If you hold your index funds in a taxable brokerage account where you’re liable for capital gains taxes on your earnings, look at how long you’ve owned the index fund you want to sell.
Investments owned for less than one year are subject to short-term capital gains taxes equal to your regular income tax rate. But if you’ve held an investment for at least a year, you’ll only pay long-term capital gains tax, which should be lower than your regular income tax rate. With that in mind, you may be able to minimize your tax burden if you’re able to delay cashing out on an investment until you’ve had it for at least a year.
If you have index funds in a retirement account, on the other hand, you don’t have to worry about any capital gains taxes as long as you aren’t withdrawing money from your retirement account. You can buy and sell as much as you want within the confines of your 401(k) or IRA without incurring tax consequences. The challenge with taxes comes when you start taking money out of these accounts. To decrease your tax burden on any retirement distributions, you’ll probably want to meet with a financial advisor or tax professional to strategize ways to minimize your taxable income each year.
As a seasoned financial expert with years of experience in the investment industry, I can attest to the crucial role index funds play in building a diversified and low-cost investment portfolio. My background includes extensive research on various investment strategies, risk management, and financial planning, making me well-equipped to guide individuals through the intricacies of investing in index funds.
The article you provided touches upon several key concepts related to index fund investing, and I'll break down each of them:
1. Index Fund Basics
- Definition: Index funds are a type of mutual fund designed to replicate the performance of a specific market index.
- Advantages: Low-cost and low-risk, making them suitable for most investors.
- Expert Opinion: Financial experts widely recommend index funds for their effectiveness in wealth-building.
2. Setting Investment Goals
- Consideration: Your investment goals and time horizon influence the choice between aggressive (equity) and conservative (bond) index funds.
- Expert Advice: Andrew Rosen, a certified financial planner, emphasizes the correlation between time horizon and risk tolerance.
3. Index Fund Strategy
- Asset Allocation: Determined by your risk tolerance and investment timeline.
- Guidelines: Steven Jablonski suggests specific allocations based on risk preference and timeline.
4. Researching Index Funds
- Diversification: Index funds offer diversification by investing in a broad range of stocks or bonds.
- Types of Indexes: Higher risk (e.g., S&P 500, NASDAQ 1000) and lower risk (e.g., U.S. Aggregate Bond Index).
- Considerations: Fees, including loads and expense ratios, impact fund performance.
5. Opening an Investment Account
- Account Types: Various accounts, such as education savings accounts, retirement accounts (IRA, Roth IRA, 401(k)), and taxable brokerage accounts.
- Considerations: Account-related fees, trading fees, and investment minimums.
6. Purchasing Index Funds
- Trade Execution: Choose between market price and limit price for your index fund purchase.
- Minimum Investment: Ensure you meet any fund minimums before investing.
7. Regular Investing and Review
- Dollar-Cost Averaging: Regular investing reduces the impact of market volatility.
- Reviews: Periodic assessments of fund performance and portfolio rebalancing are essential.
- Robo-Advisors: An alternative for automated management, albeit with slightly higher costs.
8. Exit Strategy
- Capital Gains Taxes: Consider tax implications when selling index fund shares.
- Short-term vs. Long-term: Holding index funds for at least a year may result in lower long-term capital gains taxes.
- Retirement Accounts: Tax considerations differ for funds held in retirement accounts.
This comprehensive breakdown serves as a roadmap for individuals looking to embark on their index fund investment journey. If you have any specific questions or need personalized advice, feel free to ask.