If you’re considering investing in index funds but don't know where to start, read this article that summarises 5 simple steps to get started.
AtoZ Markets –Index fund investing is a popular form of investing. This is a low-cost and easy-to-implement investment strategy that can be used by both professionals and beginners alike. It is easy to learn how to invest in index funds, especially if you have the right guidance.
All the information you need can be summarised in five easy steps. We'll show you how to do that below.
Five easy steps to invest in index funds
- Select a trustworthy broker
- Choose the best investment account
- Decide Your Initial Deposit
- Choose Your first index fund
- Plan of action and maintenance
Before we proceed, let's define what an index fund is.
What is an index fund?
An index fund is a basket of investments with the goal of tracking a particular index. There are several common stock market indices you’ve likely heard of. These include the Russell 2000, S&P 500, and NASDAQ composite indices.
Each index tracks the performance of a specific group of investments, usually stocks, with a related theme or topic.
If you look at the history of index funds compared to actively managed funds, index funds tend to win about 80% of the time. It's also important to remember that the current situation is temporary. Historically, you are likely to get a better annual return if you invest in the stock market than if you just let your money sit in the bank account, thanks to compound interest. Just remember to invest in the long-term and only invest money that you won't need for at least five years or longer.
Five steps to invest in index funds
Now that you understand what index funds are and what they can do for your portfolio let’s break down the 5 steps to invest in them.
Step #1: Select a Trustworthy Broker
A broker is necessary when you plan to invest in index funds. There are two types online brokers available: Robo-advisors and traditional brokers.
- Traditional brokers
Online brokers that allow you to manage your investments are traditional. Fidelity and Schwab are among the top brokerages for mutual funds index funds. Vanguard is a close second.
- It has low fees
- You can customize
- You have 100% control of your investments
- This requires a little more attention and oversight
- Manual tax optimization is required
Robo-advisors can be used online to do 99 percent of your work. Most cases require you to answer a series of questions before opening an investment account. The advisor will then automatically choose the right investment vehicle for you based upon your answers.
- It is easy to set up
- Portfolio rebalances and is automatically managed
- Tax-loss harvesting capabilities are possible (which can sometimes save money but is complex).
- A little more expensive
- Not customizable
Step 2# Choose the best investment account
If you already found an online broker that you’re satisfied with, you can then choose the type of account that you want to open.
It's usually advised to first max out tax-advantaged accounts (like Roth IRAs) and then deposit additional funds into a personal brokerage account. We've listed below, three of the most common types of investment accounts to help you decide where to start.
1. Personal Brokerage Account: A basic and flexible account with few limitations (but also no major tax benefits).
- Without tax benefits
- Limitless contributions
2. Traditional IRA (or 401k): Retirement accounts that provide tax benefits when contributing funds into the account.
- Can contribute money pre-tax
- Annual contributions limited ($19,500 for 401(k)s, $6,000 for IRAs)
3. Roth IRA: A retirement account that provides tax benefits when withdrawing earnings.
- Can withdraw earnings without taxes (after age 59.5)
- Annual contributions limited ($6,000 for IRAs)
This is not an exhaustive list, but these are the top choices for beginners and all you need to know to get started.
Step 3# Decide your initial Deposit
Before you decide on your initial deposit, it is important to understand your goals. Then, create a savings and investment plan to achieve them. You should not invest money now that you will need in the future.
It is a smart idea to first max tax-advantaged accounts, such as a Roth IRA or 401k, and then to contribute any remaining savings to a personal brokerage account.
Only you, based on your income and monthly expenses, can determine the amount to deposit in investment accounts. This decision is not important. The initial deposit you make is less important than any subsequent deposits that you will make over the course of time. It is also important to understand exactly what fees you are paying. Average 401(k), charges a staggering.97% in fees. This could cost you 28% of your retirement savings. Beagle will calculate all fees so that you can see how much you're losing.
Step 4# Choose your first index fund
After you have made your first deposit, you will need to choose your first index. When you start investing in index funds, there are several investment options and asset classes to choose from.
Asset classes can be described as a broad range of investment options, such as stocks and bonds. You can buy and sell specific investments called investment vehicles. Here is a brief overview of each:
Asset Classes: Types Of Investments
- Equities/Stocks - bits of individual companies
- Bonds are a loan you can issue to a government, company, or other entity.
- Real Estate - physical property
- Cash - cash in hand or in a bank account
Investment vehicles: Where to invest your money
- Individual Stocks: Buying pieces of stocks from individual companies on the stock market like Apple or Walmart.
- Mutual Funds A collection of assets, typically stocks but also bonds or other vehicles that can be purchased by pooling money with other investors. VTSAX is a dividend mutual fund.
- Index Funds- This is a group of assets, typically stocks but also bonds or other vehicles that you can buy by pooling your money with other investors (i.e. SCHX is a large-cap ETF.
- Bonds - You can invest in individual bonds or through ETFs or various bond index funds. They are considered safer investments than stocks and offer a lower return (typically between 2% and 3% annually).
Although you might be tempted by the big S&P 500 funds, which are often highly regarded, it is a smart idea to research the market and find the best fund or index for you.
Step 5# Plan of action and maintenance
Investors should establish an ongoing strategy and maintenance program before they invest in index funds. You don't have to monitor your investments every day (which you probably don't), but you should still deposit funds each month and rebalance your portfolio annually.
- An annual Portfolio rebalancing to ensure that equities are weighed against fixed income in accordance with established goals.
- Monthly: Savings money that is based on an income- and expense-based savings plan.
Index funds do have their own risks and should not make up 100% of everyone's portfolios. Make sure you know what an index fund is, how it tends to perform, what it tracks, and the pros and cons.
From there, ensure you’re buying funds that match your investment goals and objectives, and don’t just blindly pick funds because someone told you to. In the end, an index fund can be a phenomenal investment strategy — and be very passive, yet return excellent gains over time.
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