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By Chris Taylor
November 5, 2020
Arad Golan Coll for Money

If you had to name a handful of major events that reshaped the financial world over the past few decades, one of them would have to be the rise of index, or passive, investing.

As opposed to active stock picking — or selecting individual companies you think are poised for growth — stock market index funds simply track the entire groups of securities. So if you buy shares in an S&P 500 index fund, for instance, you will own a tiny slice of all 500 companies on that list.

By the fall of 2019, passive U.S. stock funds collectively managed $4.27 trillion, edging out actively managed funds at $4.25 trillion, according to data from Morningstar. So the approach has been a winner with investors, who have voted with their wallets.

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The idea was first popularized by investing legends like Jack Bogle of Vanguard Group and Jeremy Grantham of GMO, and there is an elegant simplicity about it: If an index like the S&P 500 goes up or down, your holdings shift by the same amount.

“Index funds track the broad market, include a lot of different companies in a lot of different sectors, and are a nice low-cost way to get exposure to stocks,” says Karen Wallace, director of investor education for Chicago-based research firm Morningstar.

“And they do it in a way that doesn’t take on a lot of risk. If you have a long runway ahead of you, index funds are an excellent way to get started in investing, and give your assets the best shot at long-term gains.”

What Is an Index Fund?

The broad reasoning for stock market index funds is that stocks are the best-performing asset class over extended periods of time. They may go up or down in the short-term, but over the long run, equities return in the region of 10% a year (before inflation). To get your retirement savings to where they need to be – especially since bonds and cash are returning so little these days – stocks are going to have to be a basic building block for your portfolio.

“Equities are your growth engine, where you hope to really build your portfolio,” says Jim Rowley, head of investor research for Vanguard’s Investment Strategy Group. “They carry more risk over a shorter time horizon, but over the long-term, equity index funds are a great starting point for investors.”

One primary benefit of indexing is that you don’t have to spend all that time and effort and worry, figuring out whether to buy or sell individual stocks. Especially since individual investors are notoriously bad at stock picking anyways: Driven by our emotions, we tend to buy high and sell low, which is the opposite of what we should be doing.

Even professional investors are not great at picking winners. There is an ongoing competition between active and passive mutual funds, known as the S&P Indices Versus Active Scorecard, or SPIVA. In its most recent scoring, among large-cap fund managers, 71% underperformed the S&P 500 – the tenth year in a row of lagging the index.

That performance discrepancy is partially thanks to fund expenses. Index funds tend to have low fees, with some ultra low-cost funds charging no management fee at all. Since investment fees are deducted directly from fund performance, low-cost index funds get a big head start on more expensive active funds when it comes to fund returns.

“One main reason for index outperformance is fund expenses,” says Wallace. “If you are paying .06% in expenses for an S&P 500 index fund, while an active manager is charging 1%, that’s a huge hurdle for them to overcome. The market is very efficient, and it’s difficult for investors to get any kind of informational advantage. It’s hard to beat the market.”

How to Buy Index Funds

Steps:

1: Choose an Index

2: Pick a traditional index fund or an ETF

3: Open an account at a brokerage or other financial institutions

1. Choose an Index

Of course, not all index funds are created alike. The most popular version is the S&P 500, numbering 500 of the most prominent companies in America. But you can also buy shares in index funds that tracks the Dow Jones Industrial Average, or the Russell 1000 for larger companies, or the Russell 2000 for smaller ones, and so on.

To capture all listed stocks in America, an easy catch-all solution is a “total stock market” fund, such as those offered by Vanguard (ticker VTSMX), Schwab (SWTSX) or Fidelity (FSKAX).

To add global balance to your portfolio, and mitigate your exposure to the ups and downs of the American economy, consider international indexes as well. Popular examples include those from Fidelity (FSPSX), Schwab (SWISX) and Vanguard (VGTSX).

Large-cap and small-cap index funds: You could also buy indexes based on company size: Large caps (over $10 billion in market value), mid-caps (between $2-$10 billion), or small-caps ($300 million-$2 billion). You could buy indexes in a particular industry sector, or a specific country. Just be aware that the more you drill down into a smaller niche of the market, the more risk and volatility your index fund will tend to carry with it.

“You can easily buy an index fund that only focuses on one segment of the market, such as small-cap growth,” warns Vanguard’s Rowley. “But if you only focus on small slices of the market, you are becoming more and more concentrated. So even though a fund’s name has ‘index’ in it, that doesn’t mean it’s broadly diversified or automatically better than other investments.”

Bond index funds: Remember that indexes don’t just exist for equities, there are also bond index funds. Bonds serve as the traditional counterweight to stock risk in portfolios, giving balance and diversification in times of trouble. Younger investors should be invested primarily in equities, given their long time horizon, and then gradually shift into more fixed income over time. Vanguard’s Total Bond Market (VBTLX) is one standard option, although there are a host of different types of bond indexes as well, such as international and corporate.

In fact, suggests Morningstar’s Wallace, you could create an attractive and well-diversified portfolio with only three funds: A U.S. stock index funds, an international stock index fund, and a bond index fund.

2. Index Funds and ETFs

Once you know what index you want to track, you will need pick which type of fund you want. There are two major varieties: traditional mutual funds or the increasingly popular ‘exchange-traded funds’, also known as ETFs.

Traditional index funds are mutual funds, which allow you to buy or sell once a day, at the 4 p.m. prices. ETFs, by contrast, are index funds that trade on the stock exchange throughout the day. That means you can buy and whenever you want.

While that may add convenience, in general, most experts say you should avoid making frequent trades in your investment portfolio, which defeats the purpose of the index-investing approach.

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Index funds and minimum investments

Traditional mutual funds typically have an investment minimum of a few hundred or a few thousand dollars. Many also have premium or “institutional” share classes with investment minimums that are much higher (think $10,000 and up) but lower investment fees than the lower-minimum “investor” shares.

With ETFs the investment minimum is merely the cost of a single share. And some brokerage accounts will allow you to buy fractional shares, costing as little as $1.

3. Where to buy index funds

So where exactly do new investors go, to buy shares in an index fund? For many people the starting point might be your workplace retirement plan, known as the 401(k), or 403(b) for public employees. That plan will give you a menu of investments to choose from, most likely including a number of different indexes, to which you can direct your payroll deductions.

Outside of your workplace plan, you have other investment options as well. This can be done by opening an account at a popular brokerage, such as TD Ameritrade, Schwab, Merrill Edge or E*Trade. Or you can deal directly with the mutual fund companies themselves, such as Fidelity or Vanguard.

The account can be retirement-oriented, such as traditional IRA or a Roth IRA. Or it can also be done separately from your retirement savings altogether, in an everyday brokerage account.

All those vehicles have different tax implications for investment gains. In tax-deferred accounts like 401(k)s and traditional IRAs, you can deal with tax issues later on, when you eventually take funds out in your retirement years (when your income is presumably much lower). In taxable brokerage accounts, long-term capital gains rates (assets held for more than a year) stand at 0%, 15% and 20%, depending on your income level.

When you are buying index funds, different brokerages will have different fee structures, such as trading costs or investment minimums. The fee trend in recent years has certainly been downwards – many brokerages offer zero-cost trading these days – but you should definitely compare and contrast before opening an account that is right for you.

When you are evaluating which index funds to buy, you can do your due diligence at sites like Morningstar, which evaluates funds’ past performance relative to its peers, and awards one to five stars. There, or at other sites like Yahoo Finance, you can dive into a trove of information like expense ratios, tax efficiency, and underlying holdings.

One final thought: Don’t think that just because you are dealing with a very broad baskets of securities, there is no risk involved.

“One common misunderstanding is that people think equity index funds are totally safe,” says Wallace. “I wouldn’t say that. They are typically very diversified, but you are still investing, and taking on equity risk. Index funds are a controlled way to take on that risk, in a low-cost way.”

That certainly accounts for index funds’ growing popularity in the marketplace. In fact they are so common now, that 91% of large 401(k) plans in the country now offer them, according to the Investment Company Fact Book.

Just as with any stock investment, there are no guarantees. “But for me index funds are great way for investors to control what they can control,” says Vanguard’s Rowley. “Diversification and cost are absolutely two things you can control.”

More from Money:

Here Are 4 Big Investing Mistakes Millionaires Make All the Time

Party Like It’s 1999: Could These Tech-Heavy Mutual Funds Be Headed for a Crash?

Fractional Shares Are the Latest Craze for Small Investors. Here’s How They Work

Advertiser Disclosure

The purpose of this disclosure is to explain how we make money without charging you for our content.

Our mission is to help people at any stage of life make smart financial decisions through research, reporting, reviews, recommendations, and tools.

Earning your trust is essential to our success, and we believe transparency is critical to creating that trust. To that end, you should know that many or all of the companies featured here are partners who advertise with us.

Our content is free because our partners pay us a referral fee if you click on links or call any of the phone numbers on our site. If you choose to interact with the content on our site, we will likely receive compensation. If you don't, we will not be compensated. Ultimately the choice is yours.

Opinions are our own and our editors and staff writers are instructed to maintain editorial integrity, but compensation along with in-depth research will determine where, how, and in what order they appear on the page.

To find out more about our editorial process and how we make money, click here.

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