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How to Get Started Investing in Index Funds
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When you’re first starting out in the investing world, it can be difficult to know where to turn. Investing in index funds is a great place to begin, as it instantly diversifies your portfolio.
If you’re someone who wants to invest for retirement and to cover future living expenses, you’re probably looking for the best way to invest for the long haul. You’ll want to invest in a way that is diverse and free from burdensome trading costs. You may want to invest your money with an online stock broker, but it’s best to find a firm that offers plenty of tools and resources for the lowest fees possible.
In a lot of ways, investing in index funds with the world’s lowest cost brokers solves all these problems in one fell swoop.
5 Steps to Get Started Investing in Index Funds
- Learn what index funds are and how they work.
- Compare online brokerage firms to check for functionality and fees.
- Consider ETFs in addition to index funds.
- Open an account when you’re ready, and don’t let anything stand in your way.
- Contribute regularly over time, which will allow your funds to grow and compound on themselves over and over again.
What is an Index Fund?
At this point, you’re probably wondering what an index fund is and how this type of investment works. Simply put, an index fund is a type of mutual fund with a portfolio that aims to match or track the components of a market index. The advantages of index funds are broad and varied, but they include the fact these funds typically offer low fees, low operating expenses, and broad market exposure.
According to our resident financial advisor Matt Becker, index funds offer investors an almost ideal strategy to earn maximum returns over the years. That’s because, no matter what active investors may claim, it’s very difficult to “beat the market” with active investing.
Index funds take the guess work out of where to invest your money by socking your cash into a broad range of low-cost investments on your behalf. As an index investor, all you have to do is keep throwing money into the same investments over and over again to grow wealth at a rate that should be comparable with a market index such as the S&P 500.
But, the biggest advantage that comes with investing in index funds really boils down to cost, says Becker.
“Index funds are often the lowest-cost investments available simply because they don’t require a portfolio manager who needs to be paid. And they also don’t incur all the trading costs, taxes, and other expenses that go into some of the more active strategies,” he says.
“Index funds have a simple job: track the market. That simplicity keeps costs low, and those low costs are passed on to you in the form of higher returns.”
These are some of the reasons many investors flock to index funds above all other investments. They’re simple, they help investors keep costs down, and they tend to perform well over time.
How I Invest in Index Funds
As I’ve discussed before, I invest exclusively in Vanguard’s index funds. I’ve read multiple books by John Bogle (or where Bogle was a contributor) and I’ve found that his philosophy – and Vanguard’s philosophy – match quite well what I believe. If you want to get a good grasp of Bogle’s philosophy, try reading either of his books – I’ve reviewed The Little Book of Common Sense Investing here before, but it boils down to seeking ways to invest in a huge variety of stocks as cheaply as you can, and the way to do that is by index funds which are made up of all stocks in a specific class.
So, how did I get started? Basically, I just went to Vanguard and opened an account. They ask for information on your checking account when you create the new Vanguard account. From there, you can manage everything electronically.
For almost every Vanguard fund, the initial cost of getting into that fund directly is $3,000 (or $1,000 for Vanguard target date funds). As a result, I found myself saving my nickels and dimes until I could afford that initial buy-in. The tools that Vanguard provides allow you to make automatic investments in about any way you could imagine – rolling your dividends back into the fund, automatically investing each week or month from your checking account, and so on.
Obviously, you can buy into as many funds as you wish from this one account, each with their own automatic investment plans set up however you like.
Why go this route? The fees for investing directly are quite low – 0.1 to 0.2% of the investment in the fund, which is no problem compared to the returns you can get. Fees on ETFs of Vanguard funds (see below about this) are only slightly lower than that, but that doesn’t include the fees of buying the ETFs or the fees every time you buy more ETFs – this is always a losing proposition if you’re going to invest regularly and your brokerage charges any fees at all. If you want to set up a regular investment plan, doing it directly through your brokerage is the way to go.
Another Way to Invest in Index Funds
Another route that many people take is to use a brokerage, like E*TRADE or Schwab or TD Ameritrade. The process for investing this way is very similar – you can sign up online, provide checking account information, and start buying.
With almost all brokerages, however, each time you buy or sell you’re charged some sort of transaction fee.
In this situation, one approach is to buy an ETF (exchange-traded fund). ETFs are like stocks that represent a specific set of additional stocks, much like a mutual fund. You can buy and sell them just like any other stock, but their value is pegged to the value of the included stocks. The fees charged for these are usually lower than the same exact index fund would be – for example, the Vanguard 500 (VFINX) index fund has a 0.14% expense ratio (that’s how much Vanguard charges to manage it), while the SPDR 500 (SPY), which tracks the same exact stocks as an ETF, has only a 0.0975% ratio.
Do you invest in index funds? Why or why not?
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