Index funds can be a powerful tool to build wealth.
However, it is important to understand exactly what an index fund is before diving in. With that, let’s take a closer look in our guide to investing in indexes.
What is an index fund and how does it work?
Let’s start with an index fund definition. An index fund is essentially a mutual fund or an ETF which contains a portfolio that mirrors a designated index. With an index fund, you are not attempting to beat the market in any way. Instead, you are investing in a fund that is designed to mirror the performance of the index.
As an index fund investor, you are relying on the fact that the market tends to rise over time. You’ll find index funds are a relatively hands-off investment. A few examples of indexes that you might find available in funds include the S&P 500, Dow Jones Industrial Average, and the NASDAQ.
Most investors will seek out the best low-cost index funds to invest in. With low costs and a lack of active management, index funds can be a good investment for your portfolio.
Can you lose money in an index fund?
Before you start investing in an index fund, it is important to realize that you absolutely can lose money. The return on your investment will mirror the performance of your chosen index. Unlike investing in individual stocks, you aren’t trying to beat the market. You are simply trying to keep pace with the market’s growth.
With that, you should expect to lose money at some point in an index fund. The market can go down, and likely will fall at some point in your investment career.
So why would you invest in an index fund if you could lose money? An index fund allows you to enjoy lower expenses and passive funds that keep up with the market. Although you could invest in an actively managed fund or individual stocks, there is no guarantee that those investments would keep pace with the market. In fact, many actively managed funds are laden with fees even though index funds often outperform them.
What is the best index fund?
Not all index funds are created equally. With that in mind, it is important to understand the fees involved in a particular index fund before moving forward with a single option. Any fees will cut into your total growth, so a lower fee structure is an important feature of any worthwhile index fund.
Beyond the fee structure, assess the index that the fund is following. You may choose a different index based on your investment goals, but many investors choose index funds that mirror the performance of the S&P 500.
A few of the top index funds include Vanguard’s VOO and Fidelity’s FXAIX. Both mirror the S&P 500’s performance.
How do I invest in an index fund?
Now that you know more about index funds, here’s how to invest in index funds.
Pick the index
The first, and most important, part of investing in an index fund is choosing the right index fund for your investment goals. There are index funds that follow a wide range of indexes within the market. Take some time to determine which indexes fit into your investment goals.
It is important that you don’t rush through the selection of your index. Otherwise, your investment portfolio may not reflect your goals.
Find the right fund
Once you have selected the index you want to follow, it is time to pick the right index fund for you. As you make this selection, you should carefully assess the fees associated with various index funds. Seek out a low-cost index fund that will allow you to maximize your return on investment without the interference of fees.
Open a brokerage account
In order to invest in index funds, you’ll need to open a brokerage account. You may find index funds as an option in your employer-sponsored plan. Or you may need to open a new brokerage account that offers the opportunity to invest in your chosen index fund.
Buy the funds
With a brokerage account, you’ll be able to buy many investments including index funds. At this point, you’ll simply need to transfer the money and buy the index funds.
Stay the course
When you invest in an index fund, you are signing up for a bumpy ride. Since index funds mirror market performance, your investments will rise and fall with the whims of the market. Although the stock market has historically risen over time, there are many dramatic drops along the way.
When the market drops, it can be difficult to stick to your investment plan. With panicked investors selling their funds around you, it can be a challenge of mental strength to stay the course. However, it is critically important that you maintain your investment strategy through the ups and downs of the market that will happen over your extended investment timeline.
The bottom line
An index fund can be a great way to diversify your investment holdings with a low expense. If you are planning to invest for the long-term, you may enjoy sizable returns. If you are investing for the short-term, then an index fund may not be the best fit for you.
As you prepare to invest in index funds, take some time to build your financial foundation for a stable future.