All new investors have wondered what the smartest investment would be—the investment they can stick with for years to save for retirement or develop a passive income successfully. According to billionaire Warren Buffet, the index fund is the most ideal option for both small and large investors.
Index funds are low-cost, low-maintenance, and superbly diversified. Here’s your guide on how to buy index funds for beginners.
What Are Index Funds?
Index funds (also known as index mutual funds) are a specific type of mutual fund. Here’s a quick explanation of a mutual fund in case you’re unfamiliar with them. A mutual fund is a pool of money that’s collected from several (or many) different investors. Professional financial managers handle the money and allocate it to a variety of different investments to try and create capital. Investors don’t directly own any of the stock that the mutual fund purchases. However, each investor gets an equal share of the fund’s profits (likewise, each investor would take an equal loss).
An index fund is a mutual fund that a financial manager does not actively manage. When you invest in index funds, they hold stocks that are representative of an entire index. A market index tracks the performance of many different stocks in a specific industry or economy. Here are some of the main indexes in the United States:
S&P 500: Tracks the performance of about 500 of the largest publicly-traded companies in the U.S.
Dow Jones Industrial Average: Tracks the performance of the 30 largest U.S. companies
Bloomberg Barclays U.S. Aggregate Bond: Tracks the performance of the U.S. bond market
Nasdaq Composite: Tracks the performance of about 3,000 tech companies
Russell 2000: Tracks the performance of 2,000 smaller companies
The manager of a standard mutual fund will cherry-pick stocks from a variety of indexes. The success of the mutual fund depends on the collective success of the chosen stocks. But when you invest in an index fund, your profits will match the overall performance of the entire index in which you invested. Let’s say that you invested in an index fund that holds stocks in the S&P 500. When the S&P 500 rises in value, your profits will rise proportionally. Your profits and losses will match those of the entire sector.
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The Pros Of Index Funds
To break it down simply, here are the common benefits of index funds for beginners to understand:
Arguably the most beneficial aspect of index funds is that they’re low-cost. Index funds almost always outperform standard mutual funds over a long period, mostly because financial managers do not handle index funds. That means there are no costly maintenance fees that detract from your profits.
Index funds also come with substantial tax benefits. With an index fund, less buying and selling is going on than if you were buying individual stocks. You’ll have far less capital gains tax to pay.
Index funds are also less risky than mutual funds and individual stocks. The main goal of a standard mutual fund is to “beat” the market—that is, to invest in stocks that perform better than their benchmark indexes. However, this is very difficult to do and it often fails. It’s much safer to bet on the performance of an entire sector. Timothy Woods, owner, director, and editor of Carnivore Style says that “the most obvious benefit of investing in index funds is that your portfolio becomes instantly diversified, minimizing the likelihood of losing some or all your money”. He goes on to say “it carries low risk and steady growth and also asks for low fees”.
Index stocks tend to rise over time, so there’s a better likelihood that you’ll see good returns on your investment than if you invested in high-risk, high-reward stocks.
Furthermore, index stocks are highly diversified, which means they include dozens or even hundreds of different stocks. Your profits are unlikely to be damaged much if one or two companies suffer major losses. And the wide number of available stocks will enable you to invest in both stocks and bonds, which is the main diversification goal for many investors.
Last, but certainly not least, index funds are very easy to invest in. That’s especially important if you’re a new or part-time investor.
When you invest in an index fund, you won’t have to spend any time researching individual stocks and gauging which stocks might make the best investment. Short-term losses won’t hinder you, and you’ll also have the option to reinvest your earnings month after month automatically.
Because index funds are most cost-effective and profitable over a long period, it’s a great investment option for those seeking to develop a strong retirement fund.
The Cons Of Index Funds
Now that we have covered how they can benefit you, here the drawbacks of index funds for beginners to take note of:
Can’t beat the market
No loss protection
Fewer stock options
Unfortunately, because index funds are designed to match the market, you’ll never be able to earn more than the market. Every investor dreams of buying stocks at a company that’s going to explode in growth and profitability—the next Google or Amazon.
You won’t be doing that kind of investing with an index fund. Your profits will match the profits of the market, with no exception. There’s no doubt that a mutual fund that’s personally managed by a financial professional has the potential to yield the most lucrative returns.
There’s no loss protection with index funds, so if the market takes a nosedive, there’s nothing you can do to avoid taking a proportional loss. When you invest in individual stocks, you might have the option of ordering a stop-loss—your broker will automatically sell your stocks if they fall to a certain price. You don’t have that option with an index fund.
Lastly, you don’t get to choose which stocks are included in the index fund. There may be stocks that you don’t want, or it may exclude stocks that you do want.
It should be noted that all of these drawbacks could be countered by diversification. If you were to mix index funds with other types of investments, then you can minimize your losses and also invest in stocks that you’re willing to take a risk on. An index fund is just one tool in your investment toolbox.
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How To Buy Index Funds In 4 Steps
Let’s explain how to buy index funds, step by step. It’s a fairly easy process—you just have to know what you’re looking for. Here are the 4 steps to investing in index funds beginners can follow:
Decide Where to Buy
Select an Index
Consider Investment Minimum and Costs
Buy Index Fund Shares
1. Decide Where To Buy
First, you need to decide where you want to buy your index fund. You can buy directly from a mutual fund company or a brokerage. Later on, we’ll suggest a few good places to look. Here are some of the things you should consider when choosing a provider:
Selection: Every provider will offer a different variety of funds. The larger mutual fund companies often sell their index funds plus their competitors’ index funds. However, a broker might offer funds that have a greater variety of included stocks. Shop around and find the provider that has what you’re looking for.
Ease of Use: If you’re only looking to buy index funds, you might be better off purchasing from a mutual fund company. But if you’re looking to invest in both index funds and other types of securities—like stocks and bonds—you might prefer using a broker. A broker can handle all different types of investments for you, and there will be less paperwork come tax season.
Trading Costs: Some providers waive transaction fees, but others don’t. Mutual fund companies tend to charge a commission that’s about $20 or more. Consider your budget and the overall profitability of the index fund.
2. Select An Index
Decide which index you’d like to invest in. It should be noted that the S&P 500 is a popular index for index funds because it tracks a very wide range of large companies, and in a variety of industries. But there are plenty of other indexes to choose from that might better suit your investment goals. You can choose an index based on several different factors:
Company size and capitalization: An index may track small, medium, or large companies.
Foreign: An index might track stocks that trade on foreign or international exchanges.
Sector or industry: Some indexes track companies that are in a specific industry (for example, technology or health)
Asset type: Some indexes track stocks, while others track bonds, commodities, or cash
Growing markets: Some indexes track markets that are emerging or growing rapidly, which might make for good investment opportunities
How do you know which index you prefer? Learn as much as you can about the different indexes and pay attention to what’s going on in the trading world.
3. Consider Investment Minimum and Costs
As mentioned earlier, index funds are desirable because they’re low-cost. But that doesn’t mean that all index funds cost the same. Some have higher administrative fees than others.
Here are some of the costs you should consider:
Investment minimum: Index funds require you to invest a minimum amount of dollars. Sometimes the investment minimum can be thousands of dollars or more. Once you’ve made the investment minimum, you can continue to invest in smaller increments.
Account minimum: If you’re purchasing a mutual fund from a broker, know that your broker may require you to have a minimum amount of money in your brokerage account.
Expense ratio: This is one of the main index fund costs. It’s the percentage that you pay from your overall investment that goes toward administrative fees. The average annual expense ratio is 0.09% for stock index funds and 0.07% for bond index funds.
Capital gains: You’ll have to pay capital gains tax on index fund profits unless you hold the index fund in a 401(k) or IRA (for those of you purchasing from a broker). Typically you’ll have to pay 0.3% on returns.
4. Buy Index Fund Shares
Now you’re ready to buy index funds. Open an account with the mutual fund company or broker with the index fund you’re interested in, and begin buying shares.
The Best Index Funds For Beginners
What are the best index funds for new investors? It’s difficult to compile a “best of” list because every investor has a different budget, risk tolerance, and investment goals.
If you’re new to investing, you might consider opening an account at a brokerage firm that sells index funds. A brokerage firm is a good investment hub, and it may also offer certain invaluable benefits, like investment advice—which can help you pick an index fund. If you decide to further your investment career, you’ll appreciate the convenience of managing all your investments in one place. Here are a few brokers that offer low-cost index funds with $0 account minimums and low commissions:
As you can see, most brokers offer affordable index funds that are perfect for beginners! Compare each broker’s index fund selection and find one that’s right for you.
Alternatives to Index Funds
If you decide that index funds aren’t right for you, you still have plenty of other investment options to choose from. One option is stocks. These are shares of individual companies that you can own. You could also opt for Exchange Traded Funds (ETFs) and mutual funds, which are both different types of collections of stocks that can be actively or passively managed. To learn more about fixed-income ETFs, be sure to read our guide on getting started.
Index funds are a type of mutual fund whose profits match the gains and losses of an entire sector. Knowing how to buy index funds is beneficial because they’re low-cost, less risky, and simple to purchase and manage. However, they’re not optimal for the high-risk investor because they’ll never earn more than the market. An index fund might be a good investment for you if you’re looking for a stable long-term investment that’ll provide solid returns. It’s a terrific investment option for retirement planning.
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