How to Invest in Index Funds

Can you make better investment decisions than a professional fund manager?

Naturally, this is really difficult to say. With few exceptions, actively-managed funds boast numerous ‘advantages’ such as higher expenses, sub-par returns, and triggering more taxes. Considering these drawbacks of active investing, there is little wonder that global passive assets have recently hit $15 trillion. 📈

All this cheekiness aside, passive investing through index funds is easy and lucrative. So easy in fact that it takes three simple steps—pick a broker or fund operator, open an account, and buy shares of the desired fund.

But don’t get started just yet. While you might consider the low costs and steady returns of index funds argument enough, we mustn’t forget that you are wagering a lot of money, and passive investing has caveats and drawbacks—and active funds and other forms of investing can still be the right choice under some circumstances.

In this article, we’ll be looking at how to invest in index funds, when to do it, and when and why you might want to skip this kind of investing.

Ready? Let’s get to it! 👇

Understanding Index Fund-Investing 🔎

Vanguard’s original S&P 500 index fund turned 45 in 2021, and in all these long decades the idea has stayed the same—you can’t outperform the market. Passive funds achieve their goal by picking an index to follow and simply trying to match it.

This philosophy has so far proven very successful—the market has been growing at a yearly rate of around 10% to 12% and most broad index funds have been matching these returns. This is further compounded by lower costs of passive funds—less money eaten by fees and commissions means more money getting into your bank account.

Furthermore, a majority of actively-managed funds have a history of underperforming which has only continued throughout the covid-19 pandemic, making them overall a poorer choice. This certainly doesn’t mean that they are to be simply discarded, especially after seeing their excellent performance in May 2021 against the S&P 500 index.

So, let’s backtrack a bit and clear some of the basics. An index is a tracker of the combined performance of a certain group of securities chosen through various means. If this sounds vague it’s because indices are numerous and incredibly diverse. 

Still, perhaps the best-known index is The Dow Jones Industrial Average (DJIA), with other big and famous ones being Standard & Poor’s Composite Index (S&P 500) which tracks the 500 largest-cap US companies, and Russell 2000 Index (RUT) that tracks 2000 US small-cap companies.

Index funds, like ETFs and passively-managed mutual funds, track their chosen index in several ways. Two main means of matching an index are price-orientated and market-cap-orientated.

Price-orientated funds weigh the stock price of a particular company in an index very heavily, while market-cap-orientated ones tend to have a larger portion of their assets invested in companies with high market capitalization.

Start Investing in Index Funds (5 Steps) 👩‍🏫

While the steps we outlined already in the intro are rather simple, a life, and especially a life of an investor has many, many moving parts. Not all index funds, nor all brokers are made equal, and not all of them work with every goal, every budget.

Since most of your index investing will be a very laid-back hands-off experience, it is important you lay the groundwork carefully. Sun Tzu wrote in his famous book that one who knows himself, and the enemy need not fear the result of any battle, so let’s start by getting to know you.

1. Choose the Best Index Fund Investing Strategy for You 🏆

You should always look realistically at your budget—underspend and you are missing out on bigger returns, overspend and you might tie up money you will need in your daily life. If you invest more than you can afford you can quickly find yourself in need of a payout. 

This is bad because it triggers unfavorable taxes on stocks, and secondly, it can force you to sell at a loss—for example, we doubt anyone would want to sell all of their bitcoin as the crypto market is going through a temporary lull.

The two next major factors are very interconnected—time and risk. Essentially, the more time you have, the more risk you can afford as there will be more time for recovery. This holds particularly true when investing in index funds as the diversification they offer will further mitigate any major downward shifts.

On the other hand, less time might incentivize you to try for a bigger, quicker payout. While there are some indices with a bigger growth potential—a crypto-based bitcoin ETF comes to mind—you’d probably be better off targeting individual stocks.

This is, once again, because diversification works as a buffer against big market shifts—not only the ones that could lose you money but beneficial ones as well. Note though that any get-rich-quick scheme carries a lot of risk—whether you are buying leveraged funds, trading penny stocks, or putting your fate in junk bonds.

Warren Buffett, for example, doesn’t see trading this way as viable for the average investor and believes that going all-in on index funds can work. If you go down this road, you should remember that funds following big, stable indices like the S&P 500, as well as bond index funds are generally considered safe investments—while leveraged funds can both earn and lose you a lot of money.

2. Choose an Index Fund that Fits Your Strategy 💭

One of the major selling points of index funds is their low expense ratios. Thus, this is the first thing you should check when picking one to invest in—no matter what your strategy is. Mind though that certain fund types have higher expense ratios no matter what. For example, while a broad index fund can have a ratio of 0.03%, a socially-responsible fund is likely to be somewhat more expensive.

The expense ratio is really important as—combined with unfavorable taxes—it can make a huge dent in your returns. Let’s just look at an example with only fees in mind.

Beyond the expense ratios, most other traits you’ll be looking for when investing in an index fund will depend on your exact goals.

A Design for Every Occasion ✔️

For example, if you are looking to store your money somewhere safe, you might choose a bond index fund. On the other hand, if you aren’t too concerned with growth, but want regular income, a dividend index fund might be right for you.

One fund that combines these two traits is iShares iBoxx $ High-Yield Corporate Bond (HYG) which boasts a 0.49% expense ratio, a yield of 4.56%, and a 5-year average return of 6.10%.

On the flip side, if you are looking for good overall returns with relatively low risk, and have many years ahead of you for investing, a broad index fund can be the choice for you. This is because broad index funds are very likely to match the growth of the market which has been around 10% yearly.

Vanguard 500 Index Fund Investor Shares (VFINX)—the original index fund started in 1976—is a broad index fund with an expense ratio of 0.14%, a yield of 1.30%, and a 5-year average of 14.35%.

While there is a lot more to understanding how index funds work, these are some of the main things you should be on the lookout for when picking a fund for you—ETFs, passive mutual funds, and even some actively managed ones.

3. Determine How Much You Should Invest in Index Funds

As we’ve briefly touched upon before, it is possible to base your entire portfolio on index funds. That being said, it is far from the only asset allocation you can go for. CNBC’s Jim Cramer went on record rejecting Buffett’s advice and advocating for a hybrid investment model.

There are several ways you can approach this. A common tactic would be investing primarily in individual stocks early on, and gradually increase the portion of your portfolio taken by index funds as you approach retirement.

This is because, as we’ve said, the diversification of these funds serves as a buffer against all big price shifts—beneficial and detrimental ones alike. Essentially, this means that if a fund owns assets of, say, 20 companies and the stocks of one of those take a nose-dive, the stability of other stocks will make sure you don’t lose too much money.

On the other hand, if one of those stocks skyrockets by, say, 100% while the others stay more or less the same, it won’t double your investment. This still doesn’t mean you should forsake diversification—it remains your biggest defense against losing all your money and is an important part of modern portfolio theory for a good reason.

Furthermore, if you choose to allocate 100% of your assets to various index funds remember that they are very diverse and can fit all sorts of strategies. Such a tactic would work in a similar way to any other type of investment—seek out growth-focused and leveraged funds when feeling adventurous and desiring strong returns, and buy dividend funds if you’re after regular income, and so on.

Whichever approach you pick, remember that many index funds have a minimum initial investment. While these tend to be pretty affordable, they remain a thing to keep in mind when considering asset allocation.

4. Choose a Good Index Fund Broker 🏅

As with the funds themselves, one of the main things to look for in a broker is low prices. Fortunately, the digitalization of finance has made finding low and no-cost brokers as easy as pie. The second decision you have to make is whether you want to buy directly from the fund’s owner, or a third-party platform.

Brokers like Vanguard and Charles Schwab tend to be natural picks for many investors due to them managing very large numbers of index funds. The downside of this approach is that if you trade through Vanguard—for example—you are likely to only get exposure to Vanguard’s funds.

On the other hand, third-party brokers tend to have a great number of funds from a variety of companies on offer. One thing to be especially wary of is that many low-cost brokers have hidden fees. These tend not to be deal-breakers, but, since we’ve already seen how small fees can eat into your investments, are worth keeping an eye out for.

5. Keep Investing Regularly 📅

Since most of the index fund benefits get multiplied over time, it is usually a good idea to treat them as a long-term investment. Furthermore, unless you can really get an unbeatable price on a fund right off the bat, you should try and spread your total investment into any particular fund over a long period.

This is a fairly simple process that can be automated through your broker or robo-advisor—just pick an amount and set up regular monthly payments. The reason for this is that the market prices go up and down all the time and you will usually have little idea if you are getting a good, or bad price on any individual payment.

Recurring, smaller investments constitute a strategy called dollar-cost averaging. In a nutshell, dollar-cost averaging makes any price shifts between purchases meaningless in the grand scheme of things. 

If you invest every month for a year and the price of a share is $12 in the first month, $14 in the second, $10 in the third—and this pattern continues throughout the year—it doesn’t matter that you paid $14 four times, the overall average purchase price remains $12.

Mind though that this strategy isn’t advisable when investing in specialty funds—particularly the leveraged ones. This type of fund tries to multiply the performance of their tracked index—often two, or three times over.

While this might be appealing at first glance, the multiplication goes both ways—if an index does well you get a lot more money, but if things go awry you stand to lose two, or three times what you otherwise would have. This problem is highlighted by the recent hedge fund blunder regarding the dollar. 

Why Invest in Index Funds? 💡

When it comes to the benefits of index funds, they are numerous and rather obvious at this point. The diversification they offer provides safety while still leaving room for growth and is far easier to achieve than with individual stocks—and there are many interesting types of indices to choose from.

Firstly, their low expense ratios ensure you end up with more of your money. Secondly, since they seldom have to readjust themselves, these funds aren’t likely to trigger short-term capital gains taxes—which are far more punishing than the long-term taxes achieved when selling after holding assets for over a year.

Since actively-managed funds are the closest to index funds in many ways—instant diversification being a major selling of both—let’s do a little comparison of two big funds: Vanguard Total Stock Market Index Fund Admiral Shares (VTSAX) on the side of index funds, and Fidelity Magellan Fund (FMAGX) standing for actively-managed mutual funds.

At first glance, these two funds appear similar both having a 5-year average of a little less than 15%. However, the difference really shows with the expense ratio. FMAGX has one of 0.79% while VTSAX boasts 0.04%.

Remember the difference between 0.03% and 0.7% on a 25-year long investment from the example we’ve given before? FMAGX would end up costing you more than $20.000 more than VTSAX on a similar investment.

Another major benefit to consider is how index funds can protect you from human error and flaws. Since they simply track and try to match an index, you won’t get a chance to rush into a bad decision based on emotion. This can also protect you from greedy and dishonest fund managers as they are not at liberty to make sweeping and drastic decisions for the fund.

Drawbacks of Investing in Index Funds ⚠️

We’ve already discussed how index funds can protect you from bigger returns so we won’t talk about that at length. We can turn to Apple for an example in this case. VTSAX is an index fund that holds Apple stock—it makes up about 4% of its assets—and has a 5-year average return of 14.35%.

On the other hand, Apple stock itself has a 5-year average of 491.9%. This makes it quite clear how investing in an index fund—or any broad fund for that matter—can stifle your returns, as long as you’ve picked a winning company of course.

Looking at these numbers you might think you’d be crazy not to put a lot of money into a single, promising company, but diversification is always a worthy goal, and most successful investors, Buffett included, will tell you that gambling on stocks isn’t easy.

Another point is that since index funds simply track an index, they will go under if the market goes under. While a more hands-on manager or financial advisor wouldn’t be guaranteed to save your investments if things go south, they can still take numerous steps to at least mitigate the damage.

Many economists and policy makers see an additional danger in index funds as they believe that they are, in a way, petrifying the stock market. The nature of passive investing overwhelmingly favors established and safe bets, and since there is no one truly at the helm, there is no one to see and exploit a coming opportunity.

When Active Funds Keep Their Edge 👇

Lastly, let’s once again compare index funds to their actively managed counterparts. While active funds do tend to underperform, there are still some that do consistently beat the market. 

While there may be little wonder that a fund focusing on blue-chip stocks is doing well, Fidelity Blue Chip Growth Fund (FBGRX) presents a strong case. This fund does, on one hand, have an expense ratio of 0.79%, but it also boasts both a 5 and 10-year average of around 20%. So, we’ll assume that that could also be its 25-year average and make a similar table to the previous one.

Alternatives to Investing in Index Funds ⚖️

Since investing in Bitcoin, other cryptocurrencies, and individual stocks can be significantly better when aiming for great (but much riskier) returns, we’ll assume that you’re looking into index funds for their simplicity and security.

This makes active mutual funds and ETFs, bonds, and blue-chip stocks the main competitors of index funds. We’ve extensively compared index and active funds, so, briefly, passive funds tend to outperform them both when it comes to fees and overall returns.

That being said, active funds are making a bit of a comeback and really shouldn’t be discarded right out of the bat. Also, both index and actively managed funds are comparatively easy to use—you just have to decide which one to invest in, how often, and when to pull out.

Index funds can overall be seen as better than bonds as they offer a comparable level of security while giving more room to grow your returns. If this isn’t quite safe enough for you, remember that there are funds that specialize in bonds.

Blue-chip stocks are considered some of the best the market has to offer and it is generally a good idea to have them as at least a part of your portfolio. They also aren’t that hard to come by at reasonable prices as they have good liquidity—and periodic market adjustments present good opportunities to add them to your assets.

However, they suffer from the same problem as other individual stocks—achieving diversity with them is a lot of work. Additionally, unlike with funds, you’d have to maintain a hands-on approach—though to be fair you’d probably buy-and-hold blue-chip stocks long-term.

Popular “Easy Mode” Index Funds ✅

Disregarding leveraged funds which do require oversight—you’d usually want to pop in when gains are likely and cash-out before the inevitable decline—most index funds can be considered easy mode. They are, as we’ve discussed, by their very nature very favorable to a fire-and-forget approach.

Still, let’s take a look at several popular index funds.

Vanguard Total Stock Market Index Fund Admiral Shares (VTSAX) consist of shares from the entire US market and has a 5-year average of 14.35%, an expense ratio of 0.04%, and a 1.29% yield.

SPDR S&P 500 ETF Trust (SPY) tracks the S&P 500 index and stands as one of the oldest ETFs in existence and has a 5-year average of 17.07%, an expense ratio of 0.09%, and a  1.33% yield.

Fidelity 500 Index Fund (FXAIX) has a stellar expense ratio of 0.01%, a 1.34% yield, and a 5-year average of 14.49%.

Conclusion 🏁

Looking at these numbers, and all the benefits of index funds, it would be hard not to see why passive investing has become quite so popular. Combine that with the extreme ease of investing you might get certain that you’ve found a pathway to a cushy retirement in some tropical paradise.

But it is important to remember that the numbers are so good because the market, and the indices that track it, have been doing well over the last decade. This just might remain the case for many years to come, but the recent return of volatility to the market stands as a stark reminder not to get too reckless when investing.