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Guide: How to invest in index funds

Index Funds

With the introduction of index funds in 1975 by Jack Bogle, individual investors are now able to access low cost, diversified, passive investments.

Data from over two decades shows that 88% of highly paid, highly educated fund managers that are actively managing a portfolio fail to beat a simple S&P500 index fund which is one of the major indexes.

Meaning the average investor can outperform the experts with one simple investment if they make the right choice.

Grow Today, and many millionaires, agree that low-cost index funds are a great way to get started with investing. And today you can get started with only a few hundred dollars thanks to access to simple to use Apps.

Using a broker such as Vanguard, Fidelity, Charles Schwab or even the Grow Today App, allows you to purchase index funds very quickly with low cost.

What is an index?

An index is a grouping of securities that is done to measure the performance of the group. Indices are typically used to track the performance of a particular market or market segment, such as the S&P 500, which is an index of the 500 largest publicly traded companies in the United States.

The value of an index is determined by the prices of the individual stocks that make up the index, and changes in the value of the index reflect the overall performance of the market or market segment that it represents.

There are many different types of indices, including stock index funds, bond market indices, commodity indices, and real estate indices. Others cover markets segments like healthcare, technology or emerging markets.

Some indices, such as the S&P 500, are market capitalization-weighted, which means that the larger companies in the index have a greater impact on the index's performance.

What is an index fund?

Index funds are a type of investment fund that aims to track the performance of a benchmark index, such as the S&P 500.

They can be used as part of a passive investing strategy to gain exposure to a broad range of securities in a particular market or market segment, and are typically considered to be a lower-cost and lower-risk alternative to actively managed funds.

The company managing the fund will pool money together from all investors and buy stocks that reflect the make-up of the particular index they are tracking.

This might be managed directly by a company like Vanguard or through a mutual fund.

What is an Exchange Traded Fund (ETF)?

An exchange-traded fund (ETF) is a type of investment fund that is traded on stock exchanges, similar to stocks. ETFs hold a collection of assets, such as stocks, bonds, commodities, or other securities, that reflect the index they are attempting to replicate.

An ETF provides investors with a way to gain exposure to a particular market or market segment that is linked to an index, such as the S&P 500.

ETFs can be bought and sold on stock exchanges throughout the trading day, at the market price. They can be bought and sold in the same way as stocks and can be held in brokerage accounts, just like traditional stocks.

ETFs typically have lower expense ratios than actively managed funds because they simply track a market index and do not require research, analysis or highly paid fund managers.

ETFs are basically the same as index funds, but the main difference is that ETFs are traded on stock exchanges, while index funds are not. This means that the price of an ETF can fluctuate throughout the day based on supply and demand of the trades that day.

While the price of an index fund is determined at the end of the trading day based on the closing price of the stocks that make up the index.

How to use index funds

You might think that technology stocks are going to perform well or are currently undervalued (I'm not saying they are - this is just an example). So you might decide to pick an individual stock you think will perform well like Google or Apple or Facebook.

But rather than investing in individual stocks, you could instead buy into an index fund that tracks technology companies like the NASDAQ-100 technology sector index. This is an index that tracks 100 of the largest tech companies in the US.

By diversifying your investment into 100 companies, you will get the average return of the group. So if Google or Facebook went down you could lose money if you just invested in that one stock.

But if you invested in an index fund you have 99 other companies that might do well and you'll get the average result for the group. This will balance out your returns and reduce your risk.

You now have exposure to the sector rather than just an individual company. Depending on your investment goals, you could also use index funds as part of your 401k or Roth investments.

Do you want to bet?

Warren Buffet believed in index funds so much he bet on it. Buffett's belief was that, including fees, costs and expenses, an S&P 500 index fund would outperform a hand-picked portfolio of hedge funds over 10 years.

The hedge funds are run by highly education, highly experienced and high paid fund managers resulting in high management fees. Yet he bet $1m that a low cost, passive index fund would beat all the experts over 10 years.

At the end of 9 years, the hedge funds with the higher fees were averaging 22% return and the index fund had returned over 85%.

If the highly paid experts can't pick the individual stocks that will win or time the market, what chance do you and I have?

What index funds are available?

There are many different types of index funds, in fact it is quickly becoming overwhelming. They all follow an index, but they invest in different sectors, geographies or themes. Some of the more common ones are:

• U.S. stocks— some index funds follow a famous U.S. index, such as the S&P, or a sub-set of stocks like small-cap stocks.

• Global stocks—some index fund track stocks across all countries or stocks in a particular country or a market type (such as countries with emerging economies)

• A specific industry—many index funds only invest in tech stocks, healthcare stocks, or stocks from a particular industry.

• Bonds—some index funds follow the entire bond market or focus on one part of it.

• Alternatives—there are also index funds that follow other investment areas such as oil, gold, real estate or crypto.

The point of all this is that you don't need to buy an individual stock or bond.

Using an index fund can give you a low cost way to diversify your investment across a larger sector with one simple investment.

The benefits of index funds

The main benefits of index funds are:

• Low costs: Index funds typically have lower expense ratios than actively managed funds because they simply track a market index and do not require research, analysis and highly paid fund managers.

• Diversification: Index funds provide broad exposure to a particular market or market segment, reducing the risk of a portfolio being overly concentrated in a single stock.

• Consistency: Index funds are likely to give you more consistent returns over time closer to the average, as you have a wider range of stocks in the index.

• Tax efficiency: Since index funds do not frequently buy and sell securities, they generate fewer capital gains distributions, which can result in a lower tax bill for the investor.

• Self-cleaning: Because index funds are a form of passive investing, they automatically rebalance to reflect changes in the underlying index. If a stock in the S&P 500 is performing poorly then it is dropped out of the S&P 500 automatically and replaced by a company that is performing well enough to join that index. You don't have to do anything.

How much does an index fund cost?

Investing in index funds and ETFs (exchange-traded funds) does have some costs associated with it. The cost of investing in index funds can depend on the type of fund, how you buy it, and how much you are investing.

The main fee to be aware of is the Expense Ratio which is the percentage of your money that is paid as a management fee. As an example, the fee for the Vanguard S&P 500 Index fund is 0.03% per annum. So if you have $10,000 invested then you'll pay $3 in fees.

Typical mutual funds and actively managed funds will charge you 1-2% so you could pay $200 for a highly paid manager to not even beat the market average.

There may be fees to buy into the fund so be aware of that and there will be taxes if your get a dividend return from your index fund or if you make capital gains.

Best index fund of 2023

There are now literally thousands of index funds available. While it is great that you have a choice and the ability to easily have a low cost, diversified way to invest in many sectors, it can quickly become overwhelming.

And there is no such thing as the "best". It depends on your goals, what return you're looking for and the level of risk you're willing to take.

One of the most popular and well know indexes is the S&P 500 so if you just want to track 500 large US companies that operate in many countries and industries then this might be a good starting point for you.

If you use the listed Vanguard S&P 500 ETF (VOO) then you can easily buy in using most trading apps or systems. It has very low fees at 0.03%.

If you're looking for growth, are willing to tolerate the market ups and downs (which will happen) then an S&P 500 Index Fund might be a good choice for you and you can reduce the risk of losing money if you invest for the long term (over 10 years). 

Are index funds good for beginners?

Yes, index funds are a great choice for beginner investors. They offer easy diversification, low expenses, and no minimum investment. Plus, with automated investing services like Grow Today, it’s easier than ever to get started with index funds.

As always though, it's important to do your research and understand the risks before jumping in.

What are the risks of investing in index funds?

There is risk involved in every investment. Index investing is likely to have lower risk than picking individual stocks as you have diversification across more stocks.

But if the whole market or a whole sector goes down then the index will go down and so will the value of your investment.

Do your research to ensure you understand what you are investing in, any fees, costs or taxes you will have to pay.

As most established markets have tended to go up in the long time, you can also reduce your risk by investing for the long term. If you are unsure then you should seek professional advice.

Supercharge your index funds with other investment strategies

Investing in index funds doesn't have to be done in isolation.

• Compounding: Compound growth is the amazing result that comes when you leave your money invested. As you make money on your original investment, you also invest that money leading to grow, on your growth, on your growth. Buying index funds and reinvesting dividends and leaving gains invested will provide you with compound growth in the long term.

• Dollar cost averaging: Dollar cost averaging is where you invest a set amount of money at regular intervals, for example, $1,000 on the first of every month. This takes the emotion and decision making out of your investment strategy to provide a long term sustainable approach. Buying a set amount of index funds on a set period can provide you with a structured approach to your investing that is easy to understand, implement and stick with long term.

“By periodically investing in an index fund, the know nothing investor can actually outperform most investment professionals.“

~ Warren Buffett

Bottom line

Index investing is a great option for those looking for an easy way to get started with investing.

Index funds give you a very low cost option as there are no high paid managers actively making decisions.

Index funds allow you to diversify easily across a whole industry or sector and the fund is often self-cleaning so it's a great example of passive investing.

Index funds can be easily implemented as part of an investment approach using dollar cost averaging and if you reinvest your returns you will get the benefits of compound growth in the long term.

Coach

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