Index funds have revolutionized investing by giving ordinary people access to diversified, low-cost portfolios that track the overall market. Warren Buffett himself recommends index funds for most investors. In this guide, we will explain what index funds are, why they work, and how to start investing in them.
What Are Index Funds?
An index fund is a type of mutual fund or ETF designed to match the performance of a specific market index, such as the S&P 500. Instead of trying to beat the market through stock picking, index funds simply own all (or a representative sample) of the stocks in the index they track.
The key principle: Instead of trying to beat the market (which most investors fail to do), index funds let you own the market at very low cost. You get average returns, but average market returns have historically been excellent over long periods.
How Index Funds Work
Index funds operate on a simple principle:
- Track an index: The fund holds stocks that mirror a market index
- Passive management: No active stock picking means lower costs
- Automatic rebalancing: The fund adjusts when the index changes
- Broad diversification: One fund can own hundreds or thousands of stocks
S&P 500 Index Fund Example
When you invest $1,000 in an S&P 500 index fund:
- You own a small piece of all 500 companies in the index
- Your investment rises and falls with the overall market
- You pay a small annual fee (often 0.03% to 0.20%)
- Dividends from all 500 companies are passed through to you
Benefits of Index Fund Investing
1. Low Costs
Index funds have expense ratios as low as 0.03%, compared to 1% or more for actively managed funds. Over decades, this cost difference compounds into significant savings.
2. Diversification
One index fund can give you exposure to hundreds or thousands of stocks, reducing the risk of any single company hurting your portfolio.
3. Simplicity
No need to research individual stocks, time the market, or rebalance your holdings. Just invest regularly and let the fund do the work.
4. Better Performance Than Most Active Managers
Studies consistently show that most actively managed funds underperform their benchmark index over time, especially after fees.
5. Tax Efficiency
Index funds trade less frequently than active funds, generating fewer taxable events and capital gains distributions.
Types of Index Funds
Broad Market Index Funds
- Total Stock Market: Covers entire US stock market (3,000+ stocks)
- S&P 500: Tracks 500 largest US companies
- Total World Stock: Global stocks from developed and emerging markets
International Index Funds
- Developed Markets: Europe, Japan, Australia, Canada
- Emerging Markets: China, India, Brazil, and other developing economies
Bond Index Funds
- Total Bond Market: Broad exposure to US investment-grade bonds
- Treasury Bonds: US government bonds only
- Corporate Bonds: Company-issued bonds
Specialty Index Funds
- Sector funds: Technology, healthcare, energy, etc.
- Factor funds: Value, growth, dividend, small-cap
- Real estate: REIT index funds
Index Funds vs ETFs
Both can track indices, but they have some differences:
- Trading: ETFs trade like stocks throughout the day; mutual funds trade once daily
- Minimums: ETFs can be bought one share at a time; mutual funds may have minimums
- Costs: ETFs often have slightly lower expense ratios
- Fractional shares: Many brokers now offer fractional ETF investing
Bottom line: Both are excellent choices. Pick whichever is more convenient for your broker and investment style.
How to Start Investing in Index Funds
- Open a brokerage account: Choose a low-cost broker like Fidelity, Vanguard, or Schwab
- Decide on your allocation: How much in stocks vs bonds based on your age and risk tolerance
- Choose your funds: Start with a total market or S&P 500 fund
- Set up automatic investments: Invest regularly through automatic contributions
- Stay the course: Keep investing through market ups and downs
Common Index Fund Strategies
Three-Fund Portfolio
A simple, effective strategy using just three funds:
- US Total Stock Market Index (60-80%)
- International Stock Index (10-20%)
- Total Bond Market Index (10-30%)
Target Date Funds
Single funds that automatically adjust allocation as you approach retirement. Just pick your target retirement year and invest.
Common Mistakes to Avoid
- Checking too often: Daily monitoring leads to emotional decisions
- Selling during downturns: The biggest gains come from staying invested
- Chasing performance: Past returns do not predict future results
- Over-diversifying: Too many overlapping funds add complexity without benefit
- Ignoring costs: Even small fee differences matter over decades
Track Your Index Fund Portfolio
Pro Trader Dashboard helps you monitor your index fund investments, track your overall portfolio performance, and stay on top of your financial goals.
Summary
Index fund investing is one of the most reliable ways to build long-term wealth. By accepting market returns instead of trying to beat the market, you benefit from low costs, broad diversification, and simplicity. Start with a basic portfolio of low-cost index funds, invest regularly, and let compound growth work in your favor over time.
Want to learn more about building your portfolio? Check out our guides on ETFs explained and portfolio diversification.