How to Invest in Index Funds

When you hear the talking heads say that “the S&P is on fire” “the Dow is slightly up today”  — or lament that “the S&P’s in the dumps and the Dow has a case of the sniffles” — they’re referring to the collective return of a group of companies that are included those particular stock market indexes.

Besides being a shorthand way to take the market’s temperature, indexes also provide a benchmark to use to gauge your investment returns. The goal for active investors is to “beat the market,” or outperform the stock market index they’re competing against.

The if-you-can’t-beat’em-join-’em option to simply invest in an index fund.

An index fund is a type of low-cost, passively managed mutual fund designed to mimic an underlying index’s returns.

Why are index funds so popular?

There are many reasons why Index funds have become an investment staple since the first index fund was rolled out to investors in the 1970s by a company that would later become known as Vanguard. Index funds provide individual investors:

• Instant diversification: When you invest in an index fund, you get built-in diversification across dozens to thousands of stocks, depending on the index tracked. Each dollar you invest buys you a tiny slice of ownership in every single company in the index.
• Access to all corners of the market: The S&P 500 is just one of the many stock market indexes you can invest in. There are indexes made up of companies based on company size, industry, which stock market exchange they trade on, asset type (e.g., real estate or cryptocurrency), underlying corporate practices (such as ESG-friendly companies) and so on.
• A passive way to earn “the market’s” returns: The sole aim of an index fund is to replicate the performance of a target index, not beat it. The fund’s investments — the specific stocks and their proportions — are dictated by the makeup of the underlying index. This does away with the need for a team of investment managers to actively pick and choose stocks, which leads us to one of the biggest selling points for investing in index funds…
• Major savings on investment management fees: Because index funds are highly automated, they’re much cheaper to operate than actively managed mutual funds. We’re talking lower costs for everything from analyst salaries to high-priced research tools to keeping a well-stocked selection of Keurig pods for late-night strategy sessions. For comparison, the average expense ratio (management fee) for actively-managed funds is 0.64% versus just 0.05% on average for index funds. As in 13 times less. It’s a similar story when it comes to ETFs where the average expense ratio for actively managed ETFs comes in at 0.44% versus 0.14% for index ETFs.
• Superior returns than the majority of actively-managed mutual funds: Those lower fees may not sound like they add up to much. But they’re one of the key reasons the majority of mutual funds with stock pickers at the helm don’t “beat the market.” In fact, just 42% of actively-managed funds beat their index counterparts last year, and less than 22% outperformed their indexes over the decade through 2024, according to long-time fund tracking giant, Morningstar.

Put it all together, and you have a simple, low-fee investment choice for those who want to ensure their savings, at a minimum, keep pace with the broader stock market’s returns. This is why many investors choose index funds as a foundation for their long-term investment strategy.

Index funds are an ideal starting point for beginner investors if for no other reason than they take a lot of the complexity out of building a portfolio of stocks. Plus, built-in diversification, low fees, easy access to the stock market’s returns? Check, check and check. What’s not to like?

You don’t have to just take our word for it, though.

One of the biggest champions of index funds is none other than Warren Buffett (aka the “Oracle of Omaha” and longtime chairman of Berkshire Hathaway). Buffett has consistently recommended index investing as the best long-term strategy for most individual investors.

It’s hard to argue with one of the world’s most successful investors, especially when you consider all the plusses index funds offer:

• Convenience: Index investing requires minimal legwork from start to finish. After you make your initial investment, your work is done. The money you invest in an index fund is automatically deployed proportionately across the universe of stocks in the index and all adjustments happen without you having to lift a finger.
• Affordability: Building your own index-based portfolio would be extremely costly. You’d have to have enough money to buy individual shares of each company in the index. The minimum outlay to invest in an index fund or ETF is often much cheaper than what you’d pay for just a single share of stock. (Stay tuned for more on the specifics below.)
• Reduced risk: Because your investment is spread across numerous assets, the performance of any single stock within an index fund has a minimized impact on your overall investment returns. This broad exposure significantly reduces your ups and downs compared to a portfolio that’s concentrated in just a small number of individual stocks.
• Built-in benchmark investment returns: Index funds offer a straightforward way to make sure your savings keeps pace with the market (or target benchmark). While that may sound less exciting than aiming for market-beating returns, as we mentioned earlier, even the pros struggle to outperform the so-called ho-hum index on a consistent basis. As they say, if you can’t beat ‘em, you’re better off joining ‘em.
• Low investment expenses: There are certainly costs associated with operating an index fund. But, as we mentioned earlier, they are much lower than what you’ll pay on an actively managed fund. The result of paying less means that fewer of your investment dollars are siphoned out of your account to cover management fees. In turn, each dollar that remains invested is a dollar that continues growing on your behalf. (Hat tip to the power of compound interest!)
• Minimized taxes: Trading in and out of stocks within a mutual fund (known as “turnover”) subjects investors to capital gains taxes. Like management fees, the extra cost can eat into your investment returns, especially if you’re using a taxable brokerage account (versus an IRA) to invest. Since index funds buy and sell within the fund less frequently than actively-managed funds, your exposure to taxable events is lower.

While index funds offer many benefits, there are also certain limitations to consider:

• Lack of customization: When you buy an index fund you can’t cherry-pick individual stocks to exclude or double down on to try and influence the overall returns. To counter this, many investors use index funds as the foundation of their portfolio and add individual stocks or actively-managed funds/ETFs to try and boost their overall returns.
• Locked-in average market returns: Remember, index funds are passively managed. That means no one is actively trying to outperform the market or minimize investment losses during a downturn. Therefore, your investment returns will solely reflect whatever index is being tracked.
• No protection from general investment risk: Although equity index funds offer diversification within the fund, they do not shield you from broader stock market volatility. However, for investors with a long-term horizon — the “buy-and-hold” strategy — investing in the market, and index funds specifically, has historically delivered strong returns.
• Inappropriate for short-term savings: PSA time! Due to market volatility — those wild swings that make headlines — index funds aren’t a suitable parking spot for money you need to access in the near future. How long are we talking? That depends on your risk tolerance and if your plans are flexible enough to wait out a market downturn to avoid cashing out at a loss. In general, any money you need in the next few years (at a minimum) is better off in a high-yield savings account where your principal is safe and you’re still earning interest.

Here are the four steps to follow to get started investing in index funds:

1. Set up and fund an investment account

In order to invest in index funds you’ll need a brokerage account. This type of account allows you to access investments like index funds, ETFs and stocks.

Opening one is similar to setting up a bank account: You’ll provide personal information and then transfer money into the account. Many online brokerages have very low or no minimums to open an account. And these days the majority charge $0 in commissions to purchase ETFs, and may even offer a selection of zero-commission index mutual funds.

If you already have an IRA account at a brokerage firm, you’re set! You can either invest in index funds within that retirement savings account, or set up a separate non-retirement (taxable) account which doesn’t put a limit on how much you can deposit per year. If you have a workplace plan like a 401(k), look at the menu of investment options since index funds are commonly included.

2. Decide which market index you want to buy

One of the most popular market-tracking indexes is the S&P 500, which many people use as a proxy for “the market” as a whole. But S&P index funds aren’t the only game in town.

Here’s a rundown of the most widely used indexes and what they track:

Want exposure to the bond market, growth stocks, value stocks, socially responsible businesses,  the bond market, dividend-paying companies, specific sectors (like healthcare, energy, real estate, financial services) or alternative assets like gold or crypto? Guess what? There are index funds that let you focus on all of these investing themes and more.

3. Decide between an index mutual fund or an index ETF

For many investors just starting out, the fund vs. ETF decision comes down to much money you have handy to invest. If upfront cost is a concern, an ETF is the way to go since they generally have lower minimum investment requirements than mutual funds.

Investing in an index mutual fund: Typical mutual fund minimum initial investments can range from a few hundred dollars to several thousand to buy into the fund. After that, the rules often are relaxed and you can add small-dollar amounts (e.g., $25 – $100) to your initial investment over time.

Note: You may be able to avoid investment minimums if you buy directly through an account you set up through the mutual fund company that manages the index fund you want. Also, many of the big brokerages waive fund minimums on their own products (and sometimes even partner funds) for their customers.

Investing in an index ETF: The price of entry to invest in an ETF is simply the cost of a single share. That’s because ETFs are sold in smaller slices than standard mutual fund shares. It’s like buying stock in a mutual fund, just as you would buy shares in a large company. The price per share for index-tracking ETFs can range from less than $30 to $600 or more.

Index fund vs. ETF cost comparison

4. Monitor your account… and keep adding to it

The beauty of index fund investing is that it doesn’t require constant hands-on intervention. The key to success is letting your investments ride through the market’s ups and downs over time and let compound interest do its thing.

Remember, you’re already diversified across many stocks within the funds you buy. Further diversification is available by spreading your money across several funds that track different parts of the market (like international stocks, bonds, or other asset types you want exposure to).

That said, the sit-back-and-chill approach doesn’t mean you should ignore your portfolio completely. You’ll want to check in on your investments occasionally to make sure your allocation across different types of index funds doesn’t drift too far from your original setup.

And if you start getting an itchy trigger finger — totally natural, btw, when the market starts whipsawing as it’s wont to do — turn it into an opportunity to take advantage of fire-sale prices and invest more. In fact, one of the best things you can do for your long-term wealth is to continue to add money to your portfolio when you can. (Most brokerages allow you to set up automatic deposits on whatever timeframe you choose, such as weekly, monthly or quarterly.)

Index fund investing is designed to be simpler than building a portfolio of individual stocks. Still, choosing just one (or several) can feel daunting. Here’s how to identify the best funds for your portfolio.

1. Define your investment objective

Your investment focus – specifically, which area of the market (aka asset class) you want to invest in – drives all other fund selection decisions.

One strategy is to use a broad stock market index to serve as a slice of your overall portfolio pie and layer in more targeted index funds for further diversification. For instance, depending on your goals, you might seek more exposure to indexes that focus on fixed-income (like bonds or dividend-paying stocks), specific sectors (real estate, healthcare, energy) or even alternative assets (like crypto or gold).

2. Identify potential investment candidates

Most brokerages have great mutual fund and ETF screening tools on their platforms to help you find funds that meet your criteria. They allow you to search by asset class, sector, investment minimums, fund family (the company that runs it), analyst ratings and more.

3. Narrow down your options

It’s time to scrutinize the contenders. The top index funds have a several things in common:

• Low management fees (aka expense ratios): Don’t assume that just because it’s an index fund that it’s cheap to own. Often competing funds tracking the exact same index have (sometimes wildly) different expense ratios. Here, the choice is usually simple: Pick the cheapest one.
• Consistent performance over time: Here you’re looking for returns that closely mirror the returns of the underlying benchmark index. Note: Returns may not be identical (because management fees factor into the overall returns), but a fund should closely mimic the returns of the index it tracks. Side note: You’ll probably notice that the biggest laggards are the funds that have the highest expense ratios. Just sayin’.
• Low turnover: Index funds by nature don’t require a lot of adjustments. Because they are passively managed, any funds with a higher turnover ratio than their peers can be a sign that there’s more human intervention (buying and selling). That in turn can lead to higher taxable events within the fund which can eat into shareholders’ investment returns.

3. Dive deeper into the fund inner-workings

Curious about the mechanics of how an index fund actually does what it does? Crack open the fund prospectus – every mutual fund and ETF has one. Also take advantage of independent fund research and ratings that your broker offers. This research is especially enlightening if you’re investing in a more niche or targeted index fund.

Things to look at are the fund’s holdings (which stocks they own), how it has performed historically compared to the index it tracks, the fund’s history (how long it’s been around) and who’s running the ship.

4. Consider minimum investment requirements

The amount you have to invest will also play a role in which index mutual fund or ETF you choose. If you’re using a screening tool, you may be able to sort the list by minimum investment requirement. Also many brokers provide a list of funds that have low or even $0 minimums. Once you’re in, many allow you to add small-dollar amounts to your investment over time.

No matter what your goal, both investing in index funds on your own or using a robo-advisor can help you reach the same destination. The choice is really about how you prefer to make the trip.

To continue our travel analogy, you’ve got two options: You can map out a route and drive yourself (the DIY investing approach). Or if you’re more comfortable with someone taking the wheel (a robo-advisor), you can have a self-driving car navigate the road and take you there. In road trip-free language:

• If you’re comfortable building and managing your own portfolio and know which types of index funds you want to own, a brokerage account, a few well-chosen index funds and your can-do spirit will get the job done.
  Many DIY investors prefer the freedom they get from managing their own money and enjoy the process of researching investments and making adjustments whenever they feel like it. This approach gives you more control over which funds and ETFs you invest in. But it also requires more vigilance to stay on top of things.
• If you prefer to “set it and forget it,” a robo-advisor makes the ideal investing wing man. These automated investment management services handle portfolio construction (mainly using low-cost index funds and ETFs) and maintenance (ensuring your allocation keeps you on track to meet your goals).

It’s a solid choice if you’re new to investing, simply don’t have the time to actively manage your investments on your own. Thanks to automation, the cost of professional portfolio management is minimal (typically around 0.25% of the amount managed). Still, it is an added cost that those who manage their own money are able to avoid.

Key differences between index investing on your own or using a robo-advisor

Ultimately, both strategies are geared toward helping your money grow for the long term by ensuring your savings keep pace with the broader market.

Easy access, low upfront investment requirements and rock bottom fees are some of the reasons why index fund investing has become a go-to strategy for building long-term wealth. For new and seasoned investors, index funds offer an easy way to get exposure to the stock market’s historic growth without the hassle of having to research and pick individual stocks. Whether you choose to invest in index funds directly through a brokerage account or take a hands-off approach using a robo-advisor, following the simple “buy-and-hold” strategy is a smart step to help you achieve your financial goals.