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What’s an Index?

An “index” is a statistical tool used to measure an industry’s worth. For example, the S&P 500 is one of the most famous indexes, and it measures how well the top 500 companies in America are doing. In this case, it’s an index of the overall economy, and it’s the thing you see each night on the news when the news anchors talk about the market going up or down.

What’s an Index Fund?

Index funds are relatively recent inventions. They were first popularized by the undersung hero of investing nerd culture, Jack Bogle, in 1976.

Before Bogle, there was only one way to invest in stocks without buying them directly:by paying someone else to choose them for you, in the form of a mutual fund. You could buy a share of a fund, knowing that someone smarter than you was choosing which stocks to invest in within that fund.

The idea was that by having someone manage the fund, you’d get a better return than average — except, in most cases, you don’t. Mutual funds are still around today, and this is still true:even expert stock-pickers generally earn less than the market as a whole, as measured by the indexes like the S&P 500.

That led to a lightbulb moment for Bogle:if the index is outperforming the actively-managed funds anyway, why not just make a fund based on the index? An index fund , if you will.

How Index Funds Differ From ETFs and Mutual Funds

When you’re new to the investing world, you’ll see three terms thrown around a lot:index funds, mutual funds, and ETFs. It’s important to know how they’re different so you can pick the right one for you.

Mutual funds are a collection of stocks that you can buy a share of. They can either be actively-managed by a live human, or an index fund. You read that right:an index fund is just a type of mutual fund where the stocks and bonds are chosen based on pre-set criteria rather than a live person.

ETFs get a bit more into the weeds of how buying and selling investments actually works. ETFs are traded on the day market, instead of at the end of the day like with mutual funds. You can generally buy ETF versions of both index funds and actively-managed funds. They also have lower investment minimums, so if you have just a few dollars to spare, this might be a better choice for you.

Types of Index Funds

Index funds started out as being pegged to — well — an index. For example, an S&P 500 index fund contains all of the companies listed on the S&P 500 index. If a company drops off the index, the index fund will also make the switch, too.

Over time, though, index funds have been expanded further, to non-index things. Still, each index fund starts with pre-set rules as to what kinds of stocks and bonds make the cut into the fund. The decisions about what investments to pick aren’t made arbitrarily like they are with actively-managed funds. Here are the main types of index funds:

• Stock funds. These are index funds that hold stocks only. This is an umbrella term that can also describe other index funds, such as ESG funds.
• Bond funds. Most advisors recommend holding some bonds, and you can do that with a bond fund.
• Sector &speciality funds. These funds invest in certain sectors of the economy, like the tech industry, hospitality, or agriculture. This allows you a little more control over what you invest in if you think a particular industry is on the up-and-up, for example.
• Target-date funds. Advisors recommend you change how much you have invested in stocks versus bonds as you get closer to retirement. Target-date funds do this automatically for you, so all you have to do is choose your retirement year.
• ESG funds. These funds invest in companies that have a strong Environmental, Social and Corporate Governance (ESG) component. These are companies that benefit society, or at least don’t actively harm it. So if you don’t want to invest in the firearms or the fossil fuel industry, for example, these funds might be your ticket.

Pros and Cons of Index Funds

Index funds aren’t perfect, and you give some things up when choosing to invest in them. You’ll need to know the pros and cons of index funds to decide if they’re right for you.

Pros

There are a handful of advantages that index funds afford investors. Here are the perks of index funds.

Cheap

Most investments only charge a small fraction of your portfolio amount as payment. It doesn’t seem like much, until you do the math and see these fees can eat up around 40% of your entire returns over time, in some cases.

In contrast, index funds are just about the cheapest investment out there since they run on autopilot. By choosing them, you could have tens of thousands (or hundreds of thousands) of dollars more over time.

Smaller Tax Bills

In addition to costing less, investing in index funds also means you’ll have to pay less in taxes, too. That’s because actively-managed funds buy and sell stocks a lot, and each time they do, you might owe taxes. Index funds don’t do that as much which lowers your tax exposure.

Easy, Passive Way to Build Wealth

You don’t need to know the ins and outs of investing. Even your grandma could probably figure this out if she spent enough time at it. And once you do get this basic investing concept, there’s basically no more work to run it:just put money in the fund until you retire (or otherwise need it), and then take it out. Простой. No hassle.

Good Way to Diversify Your Portfolio

It’s important to diversify so you don’t put all your eggs in one basket. The last thing you want to do, for example, is dump every last penny you have into Tesla stock. Index funds offer an easy way to get that diversification, without actually having to do the work to personally vet each company.

Relatively Safe

Index funds tend to ride the waves of the market up and down like a pool toy. This means you can lose money if the market goes down. But you’re not doing anything super-risky, like stock options or short selling.

Cons

Although there are benefits to index funds, there are also downsides.

Not As Sexy

Getting rich by investing in Bitcoin or GameStop stock is hot right now — Paris Hilton hot, in fact. But index fund investing is the slow, turtle approach. It’s about as sexy as your grandpa — and we’re talking about now, not when he was young. No one’ll be lauding your investing genius (even if they should be) while you sit back and quietly earn a pile of money over time.

Not as Much Potential for High Returns

If you truly know what you’re doing, you have a lot of discipline, and you have a lot of time to do your research, you might earn better returns with more active investing strategies. But that’s a big if .

Not As Easy to Customize Your Portfolio

You can choose from a lot of different types of index funds. You can get bond funds. You can get ESG funds. You can even get Millenial-themed funds and live cattle- and- hog funds if you want. But you can’t customize what’s in them.

To do that, you’ll need to pick the stocks on your own. This upsets some people if, for instance, they buy an ESG index fund and find out it’s still investing in some companies they don’t agree with. You can always check the fund’s prospectus to see what’s in the mix, though.

How Do I Invest in Index Funds?

If you’re convinced yet that investing in index funds is the way to go? Here’s how you can get started in four easy steps:

1. Choose an Investment Brokerage

You can buy shares of an index fund through an investment brokerage, and even through some investing apps. So, the first step is to actually get an account with an investment brokerage. This is usually about as difficult as opening a bank account (which you’ll need to connect, after opening your brokerage account).

Some brokerages also offer their own index funds. If you think you might want to stick with these funds rather than having a broader range of options to choose from later, then it might also be a good idea to open an account here instead. The advantage is that it’s usually cheaper.

2. Choose an Index Fund

Next, choose which index fund you want. This is the most common place for many people to get stuck.

If you’re truly not sure which index funds to pick, a good start is a target-date fund, based on the date you want to retire (like “Target Retirement 2050” fund).

You can even use this for short-term goals. If you want to buy a house in 10 years, for example, you could pick a Target Retirement 2030 fund so that it’s allocated appropriately as you get closer to your shorter-term goal. You don’t necessarily have to use them just for retirement, although that’s their most popular purpose.

Another option is hiring a fee-only financial advisor for a one-time financial plan. They can recommend specific funds that you can invest in so you can DIY your retirement savings from there.

3. Place Your Order

The details of how you actually buy the index fund — such as which specific buttons to click — vary depending on which investment brokerage you chose.

This is where choosing a brokerage firm with good customer service can come in handy. Having an intuitive digital interface or being able to call their support line to get a walk-through can help ensure you have a streamlined experience.

4. Rebalance Your Portfolio

If you bought more than one index fund, you’ll need to decide what percentage of your money to keep in each fund. For example, if you have two funds, you can decide on a 50/50 allocation, 70/30, etc.

Over time, they’ll start to drift from these targets that you’ve set and you’ll need to correct them. You can do this by buying and selling shares in these funds to even it out, or just by depositing more money into the account that’s behind. Most experts recommend sitting down to do this once a year, at least.

Is Investing in Index Funds Right for You?

Index fund investing is an entire investing philosophy about taking the slow, measured, hands-off approach to earning statistically-verified returns. Rather than following stock tickers and the noise, you’re focusing on the average trend line going up over time.

So if growing your wealth with less stress and steady returns sounds like your investment style, index funds might be right for you.