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

ByG. Dautovic
June 16, 2022

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 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 invest in all the stocks that make up the index to track its performance. 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 confusing at first, so here’s an example: Say you want to invest in the S&P 500. The S&P 500, as the name suggests, consists of 500 different stocks; if you were to invest in an index fund that tracks the S&P 500, you would be investing in all 500 of those stocks. This level of diversification offers protection against the volatility of investing in a single stock.

There are a variety of different index funds available, each tracking a different market index. Once you decide which one you want to track, you can research the various index funds available and choose 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.

1. Set a Long-Term Goal

Before starting any type of investing, it's essential to have a clear goal. You will want to think about 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 a goal in mind, 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, i.e., how much to invest in index funds. For example, if you are saving for retirement and have a longer timeline, 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.

2. Choose an Index

If you want to know how to invest in index funds, you probably already have one in mind. Some of the most popular indexes include the S&P 500, Dow Jones Industrial Average (DJIA), and Nasdaq Composite.

These 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 US.

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.

3. 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.

4. 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.

5. 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.

FAQ

Can You Get Rich on Index Funds?

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No venture is guaranteed to make you rich, but over time, index funds have the potential to generate a good return on your investment. They compound over time as they make money by earning a return, reinvesting that money, and then earning a return on the reinvested capital.

How to Start Investing in Index Funds?

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The first step is to pick an index you'd like to purchase and find a tracking fund suited to your needs. There are many factors to consider, such as fees, performance, and risk, but once you’re settled on a choice, it’s time to buy shares of the index fund. Remember to monitor your investment and rebalance your portfolio as needed.

What Is an ETF vs. an Index?

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The most notable difference between an exchange-traded fund and index funds is, as the name suggests, in the way they are traded. Namely, ETFs are traded throughout the day on stock exchanges. We've explained how to invest in index funds, but we didn't mention that index funds are only traded once a day, after markets close. This difference can affect how you pay taxes on your investment, as well as the fees you pay.

About author

I have always thought of myself as a writer, but I began my career as a data operator with a large fintech firm. This position proved invaluable for learning how banks and other financial institutions operate. Daily correspondence with banking experts gave me insight into the systems and policies that power the economy. When I got the chance to translate my experience into words, I gladly joined the smart, enthusiastic Fortunly team.

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