An index fund is a type of mutual fund that measures the performance of the large market index giving you a broad market exposure at minimal costs. The investor has a share in all the companies that an index includes, like the S&P 500 index, which covers the 500 largest companies of the U.S.
Now, let’s dive deep into the step by step process of investing in Index funds.
The first step into investing in an index is obviously deciding which index is the one going to invest in. There are around 5,000 indices that the U.S equity market comprises. Out of these, S&P 500, Nasdaq composite, and Dow Jones industrial average are the most popular and closely followed by the investors.
The S&P 500, Dow Jones Industrial Average, and Nasdaq Composite cover the large U.S stocks, Russell 2000, S&P SmallCap 600 are the top indexes covering the Small U.S stocks whereas, International stocks are covered by MSCI EAFE, MSCI Emerging Markets.
In addition to these funds, there are also relatively small scale sector indices, each for the specific market. Like the Style Index indicates the value-priced stocks.
After choosing an index will have to choose at least one index that is going to track that index. We discussed the popular indices out there in the U.S. You might have more than one choice for selection of the fund.
Some index funds provide access to thousands of securities in one fund hence the investment is diversified reducing the overall risk. You must go for the one that closely tracks the index performance. Also, which index fund suits you in terms of costs. Additionally, it is necessary to check if there are any kind of conditions that might stop you from investing in it.
Buying an index share would need you to open an account. You can either open with the mutual fund company or go for the brokerage account. Before opening the brokerage account you have to check whether the index fund you have chosen is available through each brokerage or not.
The broker will manage shares of the selected index fund. It will depend on your investment nature that what option is going to serve the purpose at a cheaper rate. You can either be investing in single or multiple index funds In the former case, it will be cheaper to buy funds directly through the company, and in the latter one, it will be easy to open a single brokerage account hence all the shares will be managed via that account.
Pros of investing in an index funds
It is a lot much simpler and easy to invest in index funds as it doesn’t require any expertise to manage the shares. Moreover, the chances of getting a positive outcome are much higher as the goal is simply to match the performance of the financial market and you get the return multiplied with a huge number over the time.
As an investor, the following features of the index fund might interest you.
Less risk involved. The index fund is much safer as the owner of the single index fund gains access to the huge market involving a large number of stocks. The diversified investment pattern minimizes the chances of the losses as there are dozens or hundreds of other companies there that can maintain the overall profit.
It is cheaper. As the index funds passively manage the stock the fees are much lower because they are simple to manage. That is quite opposite to the mutual fund where stock experts actively try to beat the market average and the additional burden comes on to the investor in the form of extra fees.
Tax benefits. You will appreciate the passive investment more when you learn the advantages in the investment-related taxes as compared to the actively managed funds. In actively managed funds, doing much with the buying and selling of the shares keeps generating the capital gains that are eventually added up into your bills, that is certainly not the case in the index funds.
Long term benefits. In the index funds, an investor has less to worry about the short term market performance. Your investments are set to grow in the long run and you are totally concerned about the annual return.
Cons of investing in an index funds
Despite all its pros, there are some downsides that would differ from your investment choices.
Strategy. Its prime goal is to simply replicate or match the performance of a benchmark index. It means that you will never be able to actually beat the market. Its strategy is based on the theory that the market always wins, their focus is to match the overall risks and returns of the market.
No loss protection. In the long run, the index fund has proven itself to be a great choice but there is no control over the downside. The investor stays vulnerable to losses when the market is not doing well.
Almost no short term gains. As an investor, if you are seeking to capture big short-term gains, then for sure you should not be considering the Index funds.
No flexibility. When an investor chooses an index he has no control over the individual holdings in the portfolio. You may start to believe that one company is markedly better and would want to buy or think about disowning one, then you will have no control to change the choices.
While choosing the funds you will come up with a large number of choices. Out of them, Vanguard funds are considered as the easy start points for the new index fund investors as they give diverse categories of stocks. The following can be the four good places for you to start with the investment of $1,000.
Vanguard 500 Index. Tracks S&P 500 index in $4 annually for a $10,000 investment.
Vanguard Total International Stock Market. With an $11 annual cost, it tracks global index stocks for $10,000 investment.
Vanguard Total Stock Market. Tracks the U.S stocks of all sizes in $4 annuallyVanguard Total Bond. Tracks index of numerous bonds with an annual cost of $5.