MORE LIKE THISInvestmentmidden
Index funds are an excellent investment for building long-term wealth. This is one of the reasons why they are popular with retirees.
What is an index fund?
An index fund is a group of stocks that aims to mirror the performance of an existing stock market index, such as. An index consists of companies that represent part of the financial market and provides insight into the health of the economy as a whole.
An index fund will consist of the same investments that make up the index it tracks. In this way, the performance of the index fund tends to closely match the performance of the index, without the need for hands-on management.
Advertisem*nt
Charles Schwab | Interactive brokers IBKR Lite | J. P. Morgan self-directed investments |
|---|---|---|
NerdWallet review 4,9/5 | NerdWallet review 5,0/5 | NerdWallet review 4,1/5 |
Cost $ 0 per online stock trading | Cost $ 0 per handel | Cost $ 0 per handel |
Minimum account $ 0 | Minimum account $ 0 | Minimum account $ 0 |
Promotion Nee currently no campaign available | Promotion Nee currently no campaign available | |
Learn more | Learn more | Learn more |
How do index funds work?
Index funds do not attempt to beat the market or achieve higher returns compared to market averages. Instead, these funds try to do just thatarethe market – by purchasing shares of each company listed on a market index to match the performance of the index as a whole.
For this reason, index funds are considered a passive management strategy. This means that they do not have to actively decide which investments to buy or sell. Index funds are often used to balance risk in an investor's portfolio, because market movements within an index tend to be less volatile than individual stocks.
Why invest in index funds?
Despite the fact that fund managers do an excellent job of 'beating the market' (namely a market index), they very rarely do so. And if they do, it is very unlikely that they will continue to beat the market in the long run.
According to SPIVA, part of S&P Global, only 29% of actively managed funds beat the S&P 500 in 2019. In 2021, only 9% of these funds continued to beat their benchmark.
Actively managed funds often underperform the market, while index funds match this. As a result, passively managed index funds tend to offer their investors better returns over the long term. Plus, they cost less, as fees for actively managed investments tend to be higher.
What is an index?
For investors, an index is a group of securities, such as stocks, used to measure the health of the broader market. When you hear newscasters talk about the ups and downs of the Dow, they are talking about how well a specific index – the Dow Jones Industrial Average – did that day.
As the name suggests, an index fund tracks a specific benchmark index. Some common benchmarks for index funds include:
Index examples
S&P500:As mentioned above, the Standard & Poor's 500 is an index of the 500 largest U.S. publicly traded companies.
Dow Jones Industrial Average:This well-known index (also known as the DJIA) tracks the 30 largest American companies.
Nasdaq:The Nasdaq Composite tracks more than 3,000tech stocks.
Russell 2000-index:The Russell 2000 tracks 2,000 smaller companies. (They are also known as "small caps", referring to companies withmarket valueless than $2 billion).
Wilshire 5000 Total Market Index:The Wilshire 5000 tracks the nearly 7,000 listed American companies. It is weighted in capital letters.
From MSCI EAFE-index: Tracks the performance of large- and mid-cap stocks of companies based in 21 developed countries outside the US and Canada. It includes countries in Europe, Australia and the Far East.
" Learn more:
How much do index funds cost?
Index funds have fewer costs that eat into your returns than actively managed funds. That's because they require less work than managed accounts. You are not paying for someone to study bills and call what you need to buy. Index funds may be cheaper than other funds, but they may still incur fees. These are the most important:
Minimal investment.The minimum required to invest in a mutual fund can be as low as nothing or as high as a few thousand dollars. Once you cross this threshold, most funds allow investors to add money in smaller amounts.
Minimum account.This is different from the investment minimum. While a brokerage account minimum may be $0 (common for clients opening a traditional or Roth IRA), it does not eliminate the investment minimum for a given index fund.
cost ratio.This is one of the most important costs of an index fund. Expense ratios are fees deducted from each fund shareholder's return as a percentage of their total investment. Look for the expense ratio in the mutual fund prospectus or when looking for a mutual fund offer on a financial site.
Tax-cost ratio.In addition to paying fees, owning the fund may incur capital gains taxes if held outside of tax-advantaged accounts such as a 401(k) or an IRA. Like the expense ratio, these taxes can take a bite out of investment returns.
Diversification with index funds
Index funds are available in a range of asset classes. Investors can buy funds that focus on small, medium or large companies. Other funds focus on a sector, such as technology or energy. These indexes may be less diversified than the broadest market index, but still more so than if you bought shares of a handful of companies within a sector.
Individual stocks can rise and fall, but indexes tend to rise over time. Index funds won't give you bullish returns during a bear market. But you also don't want to lose money on a single investment that sinks when the market turns skyward. And the S&P 500 has averaged an annual return of almost 10% since 1928.
» DIVE DEEPER:Learn how to invest withVanguard index funds.
Quick Start Guide: How to Invest in Index Funds
Investing in index funds is simple. Here's a quick overview of how to do this:
1. Set a goal for your index funds
Before investing in index funds, it's important to know what you want your money to do for you. If you want to make a lot of money in a few years and are willing to take a lot of risk, you may be more interested in individual stocks or evencryptocurrency.
But if you want to grow your money slowly over time, especially if you're saving for retirement, index funds can be a good investment for your portfolio.
2. Research index funds
Once you know which index you want to track, it's time to look at the actual index funds you want to invest in. When researching an index fund, it is important to consider several factors. Here are some things to consider:
Company size and capitalization. Index funds can track small, medium or large companies. (These funds are also called small, mid or large cap indices).
Geography.There are funds that focus on shares traded on foreign exchanges or a combination of international exchanges.
Business sector or industry.You can explore funds that focus on consumer goods, technology, and healthcare-related companies.
Active type.There are funds that track bonds, commodities and cash.
Market opportunities.These funds explore emerging markets or other growing sectors for investments.
Despite the many choices, you may only need to invest in one. Investing legend Warren Buffett has said that the average investor only needs to invest in a broad stock market index to be well diversified. However, you can easily adjust your fund mix if you want additional exposure to specific markets in your portfolio. (This could mean greater exposure to emerging markets or a greater stake in small companies or bonds.)
Track your finances in one place
Find ways to save more by tracking your income and assets on NerdWallet.
3. Choose your index funds
At this point it's time to choose which corresponding index fund to buy. This often comes down to costs.
Low costs are one of the biggest selling points for index funds. They are cheap to use because they are automated to track the changes in value in an index. However, don't assume that all index funds are cheap.
They still bear the administrative costs. These fees are deducted from each fund shareholder's return as a percentage of their total investment.
Two funds can have the same investment objective (such as tracking the S&P 500) but still have management fees that can vary widely. These fractions of a percentage point may not seem like a big deal, but your long-term investment returns can be hit hard by the slightest fee inflation. Normally, the larger the fund, the lower the costs.
4. Decide where you want to buy your index funds
You can purchase an index fund directly from a mutual fund or brokerage firm. The same applies toExchange Traded Funds (ETF's). These are like mini mutual funds that trade in stocks all day long (more on this below).
When choosing where to buy an index fund, keep the following in mind:
Choice of fund.Do you want to buy index funds from different fund families? The major mutual funds manage the funds of some of their competitors. However, the selection may be more limited than what is available from discount brokers' offerings.
Ease.Find one provider that can meet all your needs. For example, if you only want to invest in mutual funds (or even a mix of funds and stocks), an investment company may be able to act as your investment center. But if you need advanced stock analysis and screening tools, a discount broker that also sells your desired index funds may be better. (If you don't have an investment account,Here's how to open one.)
Trading costs. If the commission or transaction fees are not waived, consider how much a broker or fund company charges to buy or sell the index fund. Mutual fund commissions are higher than those for stock trading, around $20 or more. Compare that to less than $10 each trading stocks and ETFs.
Impact investment.Do you want your investment to make a difference beyond your portfolio? Some foundations target companies that focus on environmental or social justice causes. Learn more aboutinfluence investments.
Commission-free options.Do they offer mutual funds with no transaction fees or commission-free ETFs? This is an important metric we use to evaluate discount brokers.
" Need help?Here ishow to open a trading account
5. Buy index funds
To buy shares in an index fund, you must open an investment account. A brokerage account, individual retirement account (IRA), or Roth IRA will all work. You can then buy the fund in the account.
When you go to buy the fund, you may be able to choose a fixed dollar amount to spend or choose a number of stocks. The stock price of the index fund and your investment budget will likely determine how much you are willing to spend. For example, if you have $1,000, you want to invest in an index fund, and the fund you are looking at sells for $100 per share. share, you can buy 10 shares.
'Do you want to cut your leg?View our selection regardingbest mutual fund brokers.
6. Keep an eye on your index funds
Index funds have become one of the most popular ways to invest for Americans because of their ease of use. Their diversity – and returns that tend to be better than actively managed accounts – don't hurt either. But passive management doesn't mean you should ignore your index fund completely. Here are some things to think about over time:
Is the index fund doing its job?Your index fund should reflect the performance of the underlying index. To check this, look at the index fund's returns on the mutual fund's offering page. It shows the performance of the index fund over different periods of time compared to the performance of the benchmark index. Don't panic if the returns aren't identical. Remember that these investment costs, even if minimal, affect the results, just like taxes. However, cautions should be raised if the fund's performance lags the index by much more than the expense ratio.
Is the desired index fund too expensive?If costs start to pile up over time, you may want to reevaluate your index fund.
Would you like to buy shares instead?If you want to be hands-on with your investments, you can explore stocks.Learn how to buy stockswith these step-by-step instructions.
Frequently Asked Questions
Is now a good time to invest in index funds?
Whether the market is falling or rising, as long as you are invested for the long term in a well-diversified portfolio, now is a good time. When the market is low, it is actually for sale and you may be able to buy an index fund for less money.
Is it dangerous to invest in index funds?
As with all investments, it is possible to lose money in an index fund, but if you invest in an index fund and hold it for the long term, there is a good chance that your investment will increase in value over time. You may then be able to sell that investment for a profit, especially if you buy that index fund when the market is low.
Are index funds good for beginners?
If you plan to invest for the long term, dips or peaks in the market become less relevant. If you're concerned about buying an index fund at a high level, keep in mind that if you've been invested in that fund for many years, the high point will seem a lot less out of the way. Check out oursinvesteringscalculatorto examine how an investment in an index fund or other security can grow over time.
Are index funds popular?
Since the first index fund was introduced in 1976, index funds have become incredibly popular. Currently, investors are moving their money out of actively managed funds and investing more in US stock index funds. According to Morningstar, actively managed funds lost $926 billion in 2022, while passive funds gained $556 billion.
Neither the author nor the editor held a position in the above investments at the time of publication.
