Investing in Index Funds: A Beginner's Guide to Passive Investing

Index funds function like a slice of a particular index market by mirroring its composition and performance. This can be great for passive investors, but also comes with some caveats.

How to Invest in Index Funds

1. Know which market index you want to draw from.
2. Decide how you’ll buy your funds.
3. Compare costs.

How to invest in index funds

If you’ve been following the gospel of investment diversification, then you’ve probably come across index funds. An index fund is a type of mutual fund (or an ETF) that’s meant to be a miniature copy of an established market index, such as the S&P 500 or the Dow Jones Industrial Average. This means that an index fund includes fractional shares of all components of a particular index and mirrors that market’s performance.

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Index funds are popular among investors who take a more passive approach to investing and are more focused on a market’s long-term growth. And because an index fund gives you access to all the stocks within a single market, you’ve got diversification built right in. Here's how to invest in them:

1. Know which market index you want to draw from.

Index funds mirror specific market indexes, so you have a number to choose from. Do you want to invest in an S&P 500 index, where you’ll have access to 500 companies across a wide range of industries? Or a Dow Jones index, which consists of stock from 30 large U.S. companies? Or maybe you want to go international, and look at the MSCI World Index, which covers 23 countries? Either way, you’ve got some options.

2.Decide how you’ll buy your funds.

Investing in index funds is pretty similar to investing in mutual funds or ETFs. You’re going to need to go through an investment platform or a brokerage, but there are a wide variety of options to choose from here. There are a huge number of investing platforms you can choose from online, depending on how involved you want to be in the whole process. With some platforms you determine when to buy and sell, whether you want to manage it yourself or have it managed for you, and at what frequency you’ll be investing. Also keep in mind that this means your fees will vary—more service equals more fees, naturally. (More on that in a minute.) Although index funds by their very nature tend to be managed less actively than, say, a portfolio consisting of individually selected stocks, you can get even more laid-back with the investing process by selecting a robo advisor, which is an automated investment service that will do the job of expensive wealth managers or investment advisors by using algorithms to create a portfolio based on your financial goals and your risk tolerance. It should be noted that robo advisors tend to invest your money in ETFs—some also invest in index funds.

3.Compare costs.

The costs of investing in index funds will depend on what investment platform you choose. Some accounts will have pretty steep account minimums (the amount of money that has to be in your account at all times), while others might have higher investment minimums. Also keep an eye out for any commissions, transaction fees, and service fees. While investing in index funds is already quite a budget-friendly investing solution because of the relatively little management they require, automated investment platforms can sweeten the deal by doing away with managers and letting an algorithm do its thing.

How many index funds should I invest in

The truth is that because an index fund covers an entire market, you only really need to invest in one to be “diversified.” As long as that market itself is diversified enough, like the S&P 500, your fund will be diversified too.

Of course, you can always enhance your assets with the help of a robo-advisor, which can help spread your money across more sectors with the help of ETFs, which can cover stocks, bonds, real estate, and international markets. That way, you’re not just stuck in one market and can diversify even further.

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