How to Invest in Index Funds for Instant Diversification
Investing is something that can be as complex or as simple as you make it.
Many people think it helps to look at fancy charts or graphs that seemingly explain trends.
Investing doesn’t have to be that complicated. There are other ways to invest that are less time-intensive. Investing in index funds is one of those alternatives.
Learning how to invest in index funds may feel daunting. It doesn’t have to be.
It’s actually easier than you’d think and could be a great way to diversify your investments quickly.
Here are some of the basics of what you need to know.
What Are Index Funds?
An index fund is a basket of investments with the goal of tracking a particular index. There are a variety of indices a fund could track.
There are several common stock market indices you’ve likely heard of. These include the S&P 500 and NASDAQ composite indices.
They can even include the total U.S. stock market as a whole.
Examples of index funds that track these indices from the best brokerages include:
- Vanguard 500 Index Fund Admiral Shares (VFIAX) - S&P 500 tracking
- Fidelity NASDAQ Composite Index Fund (FNCMX) - NASDAQ Composite tracking
- Schwab Total Stock Market Index Fund (SWTSX) - Total U.S. stock market tracking
Anyone can create an index, though.
A fund company may create an index that tracks financial companies. The Vanguard Financial Index Admiral Fund (VFAIX) is an example of this.
Another brokerage firm may create an index fund that tracks cryptocurrency prices. The Bitwise 10 Index Fund (BITW) does this.
With any type of index fund, including bond index funds, the goal remains the same. They want the returns of the index fund to match the returns of the index it follows as closely as possible.
Index funds are traditionally organized as a mutual fund.
However, index fund ETFs (exchange-traded funds) also exist and could help you in different ways.
What You Need to Start Investing in Index Funds
Investing in index funds does require you to do a couple of things before you get started.
First, you need to have an account that allows you to buy index funds. Once you have funded that account, you can start buying index funds based on that fund’s requirements.
Traditional mutual fund index funds only trade once per day at the end of the trading day.
That means:
You don’t have to try to time the perfect entry point into your investment purchase.
You simply place a buy order and buy the shares you can afford with the money you invest.
With mutual fund index funds, you can own fractional, or partial, shares of the mutual fund -- the full amount you invest will end up in the mutual fund.
If the fund is priced at $20 and you invest $50, you’ll get 2.5 shares.
Choosing a brokerage
When it comes to opening your brokerage account, you have many options to choose from.
You can open a brokerage account at a traditional brokerage firm that offers index funds. Common examples you’ve likely heard of include:
You can also open brokerage accounts with many of the newer investing apps.
Not all investing apps offer the ability to invest in index funds, though. You’ll want to make sure they’re an option before signing up.
Popular investing apps include names like:
- Robinhood (ETF index funds)
- M1 Finance (ETF index funds)
- Stash (ETF index funds)
The brokerage account types you can open depend on where you open your account. That said, you can still invest in index funds in retirement accounts, such as IRAs, in addition to taxable accounts.
In fact, you may be able to invest in index funds through your employer. They may have a workplace retirement plan, such as a 401(k).
If it has index fund investment options, you could choose to set aside money to invest in those options.
How Much Does It Cost to Invest in Index Funds
You might think index funds come with a bunch of hidden fees to invest in these assets.
That isn’t usually the case. It can happen, though.
Here are the costs you need to watch out for.
Minimum initial investment
Some mutual fund index funds require a minimum initial investment to start investing in them.
For example, the Vanguard 500 Index Fund Admiral Shares (VFIAX) has a minimum initial investment of $3,000.
Other mutual fund index funds have no minimum initial investment.
Examples include the four Fidelity ZERO index funds:
- Fidelity® ZERO Large Cap Index Fund (FNILX)
- Fidelity® ZERO Extended Market Index Fund (FZIPX)
- Fidelity® ZERO Total Market Index Fund (FZROX)
- Fidelity® ZERO International Index Fund (FZILX)
Expense ratio
Each fund has expenses it incurs to manage the investments within the fund. These charges are usually passed on to the investor.
The expenses are displayed as an expense ratio. This ratio is shown as a percentage and is taken out of your investment returns each year.
The lower the expense ratio, the less you lose to fees.
Trade fees
Some brokerages charge you to buy shares of certain mutual funds. Typically, they allow you to purchase most mutual funds from their brokerage without trade fees.
If you want to invest in a mutual fund from another brokerage, you may have to pay up to $50 per trade or more.
An example that incurs fees could be purchasing a Fidelity Freedom Fund mutual fund within your Vanguard account.
You could avoid this by opening a Fidelity account and purchasing the mutual fund within that account.
Other costs
Some investments have other costs. Make sure to check the prospectus to look for any fees you may have to pay.
While fees have been dropping overall, some funds still charge outdated fees.
One example is a load fee. Avoid these when possible.
Benefits of Index Investing
Index investing has quite a few benefits.
Instant diversification
When you invest in an index fund, you’re not buying stock in one company. Instead, you’re buying an investment that is made up of several smaller investment positions.
This is great because it doesn’t put all of your eggs in one basket. If one investment within the fund fails, you still have several others that may be performing well.
Lower overall costs
Index investing often has lower costs than active investing.
Once an index is picked, the manager must keep the index fund in line with the index’s investments.
Overall, this doesn’t require nearly as much work as actively managed funds.
For active mutual funds, fund managers are often highly paid.
This is because they need to be a high performing individual that can hopefully beat the markets with unique investment strategies.
Additionally, the fund must incur more costs with frequent trades, more research and other tools to attempt to beat the market’s returns.
Less time-intensive
Investing in an index fund may take some time upfront to find the perfect fit. After you find that fit, you merely have to manage your portfolio to make sure it stays in line with your goals.
You don’t have to research several companies regularly as you would if you owned ten individual stocks. You don’t have to watch the markets like a hawk looking for the perfect buying and selling opportunities, either.
Drawbacks of Index Investing
Index investing isn’t perfect.
Many index funds have a minimum initial investment. Sometimes, these minimums are thousands of dollars.
Not all stock index mutual funds have minimum initial investment requirements, though.
If you invested in an index fund rather than a single stock, that means you could miss out on the massive returns some fast-growing companies could provide.
Because you own a basket of investments, you won’t have a considerable position in any single company.
Common examples of these fantastic returns in the past come from companies such as Apple, Google and Tesla.
The good news is you won’t lose everything with index investing as you would if the sole company you invested in went bankrupt.
Index ETFs - A Cheaper Alternative?
While index funds are traditionally mutual funds, index ETFs also exist. These often come with even lower costs than their mutual fund counterparts. This is due to the way they’re managed.
Index ETFs are different, though.
First, they can be bought or sold throughout the trading day, unlike mutual funds.
They don’t have minimum initial investment requirements, either. Instead, you only have to have enough money to buy a single share.
The downside:
You can usually only buy index ETFs in whole share increments. This means you won’t always be able to invest an even sum each pay period, such as $500.
If the index ETF is priced at $90 and you have $500 to invest, you could only purchase 5 shares at $450. The other $50 couldn’t be invested until you have enough money to purchase another share.
Some investing apps now allow you to buy partial shares of ETFs to get around this problem.
The differences between mutual fund index funds and ETF index funds are small, but they do exist.
Consider whether a mutual fund ETF or index fund ETF helps you better reach your goals.
Summary
Now that you know how to invest in index funds, it’s time to take action. First, figure out if investing in index funds is a good way to meet your long-term goals.
If it is, look for specific index funds, such as an S&P 500 index fund, that you may want to invest in. Research them.
If it isn’t, look for other investment options that may be a better fit.
Either way, the key is to take action. If you do nothing due to analysis paralysis, you won’t be closer to reaching your goals.
