How to Invest in Index Funds


If you’re considering investing in index funds but don’t know where to start, read this article that summarizes 5 simple steps to get started.

March 6, 2021 | AtoZ Markets – Investing in index fund investing is one of the most popular forms of investing these days, and with good reason. It’s an easy-to-setup, low-cost, and effective investment strategy for newbies and professionals alike. Learning how to invest in index funds is simple too, especially when you have the right guidance on how to get started.

Luckily, all the guidance you need can be summarized in 5 simple steps, which we’ll walkthrough below.

5 simple steps to invest in index funds:

  1. Choose a reliable broker
  2. Select the right investment account
  3. Determine your first index fund
  4. Choose your blend of investment vehicles
  5. Ongoing strategy and maintenance plan

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: Pick an online broker

When planning to invest in an index fund, you need a broker. There are two types of online brokers to choose from: traditional brokers and Robo-advisors.

  • Traditional brokers

Traditional online brokers are those who let you control your investments. Fidelity, Schwab, and Vanguard are arguably the best brokerages for mutual fund index funds.

Pros:

  • Low fees
  • Customizable
  • 100% control over your investments

Cons:

  • Requires slightly more oversight and attention
  • Manual tax optimization required

 

  • Robo-Advisors

Robo-advisors are online platforms that do 99% of the work for you. In most cases, you complete a set of questions before opening an account and the advisor will automatically select investment vehicles for you based on your answers.

Pros:

  • Easy to set up
  • Automatically manages and rebalances portfolio ongoing
  • Tax-loss harvesting capabilities (which is complicated and can sometimes save you money)

Cons:

  • Slightly more expensive
  • Lack of customizability

Step 2# Select the right 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# Determine your Initial Deposit

Before determining your initial deposit, it’s best to first understand your goals and set a savings and investing plan to reach them. Anything you invest now should not be money that you need in the immediate future.

As stated in step 2, it is usually smart to first max out tax-advantaged accounts (like a Roth IRA and 401k), and then contribute leftover savings to a personal brokerage account.

At the end of the day, only you can decide the right amount of money to deposit into investing accounts based on your specific income and monthly expenses. Don’t stress too long over this decision, your initial deposit is actually less important than the ongoing deposits you’ll make over time. Moreover, it is important to know exactly what you’re paying. The average 401(k) charges a whooping .97% or more in fees! That could be costing you 28% of all your retirement money. Let Beagle find all of those fees for you so you know how much you are losing on fees.

Step 4# Determine your first index fund

Once you’ve made your initial deposit, you need to pick your first index. There are a few asset classes and investment vehicles to choose from when starting to invest in index funds.

Asset classes are broad categories and types of investments, like stocks and bonds. Investment vehicles are specific investments that you buy and sell. Below is an overview of both:

Asset classes: Types of investments

  • Equities / Stocks – pieces of individual companies
  • Bonds – a loan that you issue to a company, government, etc.
  • Real Estate – physical property
  • Cash – money on hand or in a bank account

Investment vehicles: Where you invest your money

  • Individual Stocks – buying pieces of individual companies in the stock market, like Apple and Walmart.
  • Mutual Funds – A group of assets (typically stocks, but can be bonds and other vehicles) that you can purchase by pooling money with other investors (i.e. VTSAX, a dividend mutual fund).
  • ETFs & Index Funds – A group of assets (typically stocks, but can be bonds and other vehicles) that you can purchase by pooling money with other investors (i.e. SCHX, a large-cap ETF).
  • Bonds – Bonds can be invested individually or through ETFs and various bond index funds. They offer a lower return (typically 2-3% annually) and are viewed as safer investments than a stock.

While you may be tempted to buy one of the really big, popular S&P 500 funds they talk about in the news, it’s a good idea to do your own research and choose the fund and index that make the most sense for you.

Step 5# Ongoing strategy and maintenance plan

Before you invest in index funds, it is important for investors to set an ongoing strategy and maintenance plan. While you don’t need to check on your investments daily (and you probably shouldn’t), you should still be depositing funds monthly and rebalancing your portfolio annually.

  • Annually: Rebalance the portfolio to ensure the weight of equities vs fixed income is in line with set goals, as needed.
  • Monthly: Deposit money based on an ongoing savings plan that fits your monthly income and expenses.

Conclusion

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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