Billionaire investor Warren Buffett has long suggested that the best strategy for most people is to simply buy and hold a low-cost S&P 500 index fund.(1) He’s not the only proponent of this simple investing approach — index fund investing is often said to be the best strategy to build a well-diversified investment portfolio.
Index funds are low cost, easy to buy and can offer broad market exposure — a single purchase can instantly diversify a portfolio. Whether you’re a beginner looking to start investing or a seasoned investor seeking to diversify your portfolio, index funds can serve a valuable purpose as the foundation of a portfolio. Learn how to invest in index funds and how to choose the right index funds for your investment goals.
What is an index fund?
An index fund is a type of mutual fund or exchange-traded fund (ETF) designed to track the performance of a specific market index, such as the S&P 500, the Dow Jones Industrial Average or the total stock market index.
Instead of relying on active management by fund managers to select and trade individual stocks or bonds, index funds passively replicate the composition of an index by holding a diversified portfolio of securities in proportions that mirror the index’s weighting.
The goal of an index fund is to closely match the returns of the index it tracks, providing investors with broad market exposure at a low cost and with minimal turnover.
How to invest in index funds
Investing in index funds is relatively straightforward. It’s as simple as buying any US-listed stock or ETF. Here’s how to buy index funds in three steps:
1. Research and choose an index fund
Start by researching different index funds available in the market. Hundreds of index funds are available to choose from, including those that track large companies, small companies, foreign companies, commodities like gold and silver and more. Popular index funds are:
- S&P 500. The S&P 500 is a market-capitalization-weighted index comprising 500 of the largest publicly traded US companies, representing various sectors. Popular companies in this index include Microsoft (MSFT), Apple (AAPL), Nvidia (NVDA) and Amazon.com Inc (AMZN).
- Russell 2000. The Russell 2000 is a market-capitalization-weighted index tracking the performance of approximately 2,000 small-cap US stocks, representing the bottom two-thirds of the Russell 3000 Index. The top three holdings by market value as of June 2024 are Super Micro Computer Inc (SMCI), MicroStrategy Inc (MSTR) and Carvana (CVNA).(2)
- Nasdaq Composite. The Nasdaq Composite is a market-capitalization-weighted index that tracks the performance of over 2,500 stocks listed on the Nasdaq Stock Market. It emphasizes technology and growth sectors, with some well-known companies including Apple, Microsoft, Amazon, Alphabet (GOOGL), Meta Platforms (META), Tesla (TSLA) and Netflix (NFLX), among others.
Numerous ETFs and mutual funds can track each index fund. For example, more than 15 ETFs track the S&P 500. The performance of all these ETFs is virtually the same; the difference is which company owns the index — whether it’s Vanguard, MSCI, iShares, Invesco or others — and the applicable fees. When researching index funds, consider factors such as the index being tracked, the fund’s expense ratio, historical performance and any minimum investment requirements.
2. Open and fund an investment account
You’ll need an investment account with a brokerage firm or financial institution to you buy the index fund once you’re ready. These can include a taxable brokerage account or a retirement account like an individual retirement account (IRA). If you have a 401(k), chances are it offers access to a selection of index funds.
The best brokerage accounts charge low fees and make it easy to sign up and invest. Some may offer new account signup bonuses, which you can apply toward your index fund purchase.
But also look at the overall cost of having an account with a broker. Consider trade fees and accounts fees, such as inactivity fees and withdrawal fees. Some brokers charge upwards of $100 for each ACATS transfer, which is an online process that lets you easily move assets from one broker to another. Consider other investment options as well if you want to invest in more than index funds.
Once you’ve chosen a broker, deposit funds to invest.
3. Place your order to buy the index fund
With a funded account, log in with your broker and place a market order or limit order to buy shares of the chosen index fund. Specify the amount of money you want to invest or the number of shares you wish to purchase.
Many brokers offer fractional share trading, which lets you invest specific dollar amounts instead of needing the current market price. For instance, the Vanguard S&P 500 ETF (VOO) trades at $498.58 at the time of this writing. However, some brokers will let you invest with as a little as $1.
Investing in index ETF funds vs. mutual funds
Most ETFs are similar to traditional index mutual funds in that they are low-cost and track a major underlying index, though there are several key differences:
Fund type | Trade and listing | Pricing | When you can buy and sell | Minimum investment | Fees |
---|---|---|---|---|---|
ETFs | Traded like shares on the stock exchange | Market value, depends on stock market performance | Any time during the trading day | Lower minimum — sometimes under $100 |
|
Mutual funds | Unlisted and bought from issuer | Net asset value of underlying securities | At the end of the trading day | Can require as much as $2,500 |
|
Benefits of investing in index funds
- Diversification. By holding an index fund, you have exposure to multiple companies or assets.
- Cost. Passively managed index funds cost less than actively managed funds.
- Easy to trade. Buy or sell ETF funds whenever you want during market hours and as easily as you would trade any individual stock.
Risks of investing in index funds
- Index concentration risk. Some indexes, such as the S&P 500, may be heavily weighted toward specific sectors or industries, leading to concentration risk. If these sectors or industries underperform, it can negatively impact the performance of the index fund.
- Tracking error. This could cause the ETF price and the market index to slightly differ. Add in the ETF’s annual fee and you could be looking at a worse performance than the market index it was supposed to match. Luckily, this rarely happens with popular index funds.
- Lack of flexibility. Index funds passively track the composition of a specific index and do not allow for active management or stock selection. As a result, investors are unable to capitalize on opportunities to outperform the market or adjust the fund’s holdings based on changing market conditions.
Bottom line
Investing in index funds offers a simple and low-cost way to get broad market exposure, making them an attractive option for long-term investors seeking diversified, low-maintenance investment portfolios. To invest in index funds, pick an index, compare and choose a broker and buy your shares. But consider risks such as tracking errors and concentration risk before making investment decisions.
Frequently asked questions
Can I invest in index funds by myself?
Invest in index funds by yourself by opening a brokerage account or IRA that offers ETFs or mutual funds, searching for the index fund by its ticker symbol and then buying shares.
How much does it cost to invest in index funds?
Invest as much as you want without any minimums. However, each ETF has an annual fee, called the expense ratio. For most ETF this is less than 1% each year.
Are index funds good for beginners?
Index funds are one of the best investments for beginners because they’re low-cost, easy to buy and can help diversify your portfolio. If a company is delisted or listed in the index, the fund will adapt its portfolio accordingly.
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