How to Invest in Index Funds: A Step-by-Step Guide

Buying individual stocks is not the only way to invest. Did you know that you can buy a whole range of stocks in a single, low-cost investment?

Index funds have several notable advantages over other types of investments. They are typically more diversified and tend to have lower expense ratios than other mutual funds, making them a cost-effective option.

If you are intrigued but unsure how to invest in index funds, give our step-by-step guide a read before you kick-start your investment journey.

How Index Funds Work

Index funds are mutual funds that track a specific market index, such as the S&P 500 or the Dow Jones Industrial Average. The fund manager will use “indexing” to invest in all the stocks that make up the index to track its performance, as a form of passive fund management. When you invest in an index fund, you are essentially investing in a basket of stocks, which immediately diversifies your portfolio.

Index fund investing can seem perplexing at first, so here’s an example: Say you want to invest in the S&P 500. The S&P 500 Index, as the name suggests, represents a market-capitalization weighted index of the 500 largest companies in the US. 

If you were to make a decision to invest in an index fund that tracks the S&P 500, you would essentially be investing in all 500 of those companies’ stocks. This high level of diversification offers strong protection against the volatility of investing in a single stock.

There is a wide variety of different index funds available, each tracking a different market index. Once you zone in on the one you want to track, you can delve deeper and research the diverse index funds available, before choosing the one that best meets your needs.

How to Invest in Index Funds

Now that you know the index fund basics, let's see how you can start investing in them.

Set a Long-Term Goal

Before starting any type of investing, it's essential to have a clear and well-thought out goal. You will have to determine your long-term financial goals: Are you saving for retirement? Building up an emergency fund? Saving for a specific purchase, like a house or car?

Once you have that goal figured out, you can start thinking about how much you need to save within a specific period. This will help you determine how much risk you are willing to take on, or exactly how much to invest in index funds and still feel safe. For example, if you are saving for retirement and have a longer timeline to work with, you may be able to take on more risk than if you are saving for a short-term goal.

Patience is vital, especially with index funds. These investments suit 10- or 15-year timelines, preferably longer, as they take time to grow.

Also, determine whether you'd prefer a conservative or aggressive approach. While both have pros and cons, a measured approach may be best if you're new to investing or have a shorter timespan available. More aggressive access may be better if you're a seasoned investor with a longer timeline.

Choose an Index

If you’re seeking information and tips on how to invest in index funds, you’re more than likely to already have one in mind. Some of the most widely-known indexes include the S&P 500, Dow Jones Industrial Average (DJIA), and Nasdaq Composite.

These market indexes reflect the performance of large US companies, but there are also international indexes, such as the MSCI EAFE Index, which tracks developed markets outside of the United States.

Most beginner investors start by investing in the S&P 500 index because it offers a good balance of risk and reward. However, there are various indexes to choose from, so it's essential to do your research.

If you’re a newbie and not sure how to invest in index funds, Robinhood might be a good option. Namely, investment apps are user-friendly platforms that make it easy to trade stocks and other investments without high fees.

Pick the Right Fund for Your Index

Once you've decided on an index, start researching the different index funds available. Even though most of the funds perform similarly, there are a few things to consider:

• Expense ratio: This is the fund's annual fee, so look for a fund with a low ratio. There are even some index funds (e.g., Fidelity) that offer a zero expense ratio.
• Minimum investment: Knowing how to invest in low-cost index funds isn’t the only thing you should care about. Some funds have a minimum investment, so make sure you have enough money to meet the initial requirements.
• Investment objective: Finally, each fund serves a different purpose; the best thing would be to check whether the fund's objective aligns with your investment goals. You can even find funds that track benchmarks for socially or environmentally conscious companies.

Buy Shares

Once you've chosen an index fund, it's time to buy shares. First, you'll have to open an online brokerage account or one for retirement, such as a 401(k) or traditional or Roth IRA.

Once you've opened an account, you can begin buying index funds’ shares. Make sure to check for fees and fine print: Some brokers charge their customers for share purchases, so it's best to open an account with the index fund company you’re buying funds from, provided you don't mind having all your investments in a single account.

Index funds are best suited for long-term goals, so you should be in for the long haul - don't expect to see immediate results.

Follow-Up and Rebalance

Even though this type of investment is quite simple, you shouldn't forget to monitor your index funds regularly. Tracking your fund's performance will help you see whether it's meeting your expectations.

You should also decide how much to invest in index funds on a monthly basis. Once you've set an amount, make sure to stick to it. If you find it difficult to set up a profitable sum, you can use one of the many compound interest calculators available online.

Finally, rebalancing your assets is vital to maintain your portfolio's risk level and peace of mind, since it will save you from overexposure to any particular asset class.

Bottom Line

Index fund investing has become increasingly popular in recent years as a way to participate in the stock market without having to pick individual stocks. Buying them is a good option for those looking to invest long-term, as they offer growth and diversification potential, reducing risk.

When done correctly, investing in index funds can be a simple and effective way to grow your savings over time. Just remember to monitor your investment and ensure it's still on track to meet your goals.