How to Invest in Index Funds

last updated

An index fund investing how to: what they are, why they make sense, and where to buy them at the best prices.

Most passive investors want to find a balance between reliability, safety, and ease. Instead of spending their days trading stocks looking for 1% here or there, they sleep easier at night earning a decent average rate of return of 8% every year (over a period of decades).

No investment can guarantee that in any given year, but the historical trend suggests that a very simple investment can do that well, if you invest consistently and carefully. That investment is the broad US stock market. Of the myriad ways to approach this problem, John Bogle's The Little Book of Common Sense Investing suggests that index fund investing is the best starting point for novices and passive investors.

Index Funds versus Mutual Funds

An index fund is like a mutual fund. A mutual fund is an investment vehicle where multiple investors pool their money and a money manager uses the sum total to buy and sell individual securities. Of course, you'll pay a fee for that fund. An index fund is an investment vehicle where multiple investors pool their money and the individual investments track a single stock market index. This distinction is subtle; rather than relying on the expertise or whims of a money manager, all trades follow the underlying securities which make up the index. Perhaps that's the 30 stocks in the Dow Jones Industrial Average. Perhaps that's the S&P 500 Index. It could be many things.

You'll pay a fee for an index fund as well, but the fee is much, much lower than for a mutual fund because the overhead of managing the fund is much, much lower. This improves your return (by lowering your costs) and reduces your risk and churn.

Index Funds versus Individual Stocks

You can buy index funds the same way you would individual stocks; often that's as easy as searching through the options for your online broker. (You can buy all sorts of interesting things online; all sorts of exchange-traded funds.)

While an index fund rarely offers the exciting growth opportunity of stocks, it can often reduce risk because the index represents multiple stocks. In the case of a broad market index such as the S&P 500 or the Russell 2000, the index may represent multiple economic sectors. (Alternately, an index representing the Dow may overrepresent large blue chip stocks just as a NASDAQ index may overrepresent tech stocks.)

None of this is inherently bad; it's just information you should keep in mind.

Should you buy individual stocks or index funds? That depends on what type of investor you are.

How to Invest in Index Funds

John Bogle's work as the founder of the Vanguard investment company led him to create the first index fund. Even still today, the Vanguard 500 index fund is a gold standard against which other investments are managed. You can invest in that index fund (or multiple other fund options) by opening an account with Vanguard directly—no broker needed. This is a great option if you're starting with a small amount, say $100 or $1000. You can open a fund with a minimal investment.

If you already have a discount broker, you will have a wide range of indexes from which to choose. You can just as easily pick one of Vanguard's offerings there as with Vanguard itself, or from countless other funds. In this case, make sure to understand what the underlying index tracks and look for the lowest investment fees when you have the option of multiple funds which track the same index. Remember, the most important of Bogle's insights into index fund investing is to keep fees and costs as low as possible.

Investing in Index Funds: 401(k) Version

There's one twist, if you have a company-sponsored 401(k): you may have limited funds from which to choose, and those choices rarely include John Bogle index fund opportunities. It's a sad fact of these programs, especially given that the costs on these funds are higher than you could get as a self-directed investor. In this case, you must choose carefully to minimize fees (within the possibilities you have). You can often find an analogue to the S&P 500 index fund, and it's often the best choice. Sometimes you may need to talk to your fund administrator to see if you can get other options.

It won't always work, but sometimes being assertive in a couple of conversations can save you thousands and thousands of dollars over the lifetime of your investments.

What is Earnings Season? | What is a Stock Bubble?