Index fund investing is one of the most powerful wealth-building strategies available to everyday investors. It offers a simple, low-cost way to own a diversified portfolio without spending hours researching individual stocks. In this guide, we will explain everything you need to know to get started with index investing.
What is an Index Fund?
An index fund is a type of mutual fund or exchange-traded fund (ETF) that aims to match the performance of a specific market index. Instead of trying to beat the market, index funds simply try to be the market by holding all (or a representative sample) of the securities in that index.
The simple version: An index fund is like buying a tiny piece of hundreds or thousands of companies in one single purchase. When those companies grow, your investment grows with them.
How Index Funds Work
When you invest in an index fund, your money is pooled with other investors to purchase shares of every company in the target index. For example, an S&P 500 index fund holds shares of all 500 companies in the S&P 500 index, weighted by their market capitalization.
Example: S&P 500 Index Fund
You invest $10,000 in an S&P 500 index fund. Your money is automatically spread across:
- Apple, Microsoft, Amazon, and other large tech companies
- Healthcare giants like UnitedHealth and Johnson & Johnson
- Financial institutions like JPMorgan and Berkshire Hathaway
- Plus 490+ other companies across all sectors
If the S&P 500 gains 10% over the year, your investment grows to approximately $11,000 (minus small fees).
Types of Index Funds
1. Broad Market Index Funds
These funds track the entire stock market or large portions of it. The most popular options include:
- Total Stock Market Index Funds: Track thousands of US stocks of all sizes
- S&P 500 Index Funds: Track the 500 largest US companies
- Total World Stock Index Funds: Track stocks from around the globe
2. International Index Funds
These funds focus on stocks outside the United States:
- Developed Markets: Companies in Europe, Japan, Australia, and Canada
- Emerging Markets: Companies in China, India, Brazil, and other developing economies
3. Bond Index Funds
These funds track bond market indexes and provide income and stability:
- Total Bond Market Index Funds: Track thousands of investment-grade bonds
- Treasury Bond Index Funds: Track US government bonds only
Why Index Funds Beat Most Active Managers
Research consistently shows that most actively managed funds fail to beat their benchmark index over the long term. Here is why index funds have the edge:
- Lower costs: Index funds typically charge 0.03% to 0.20% in fees, while active funds often charge 1% or more
- No manager risk: You do not have to worry about a fund manager making bad decisions
- Tax efficiency: Index funds trade less frequently, resulting in fewer taxable events
- Consistency: You always know what you own and how your fund will perform relative to the market
Did you know? Over a 15-year period, approximately 90% of actively managed funds underperform their benchmark index after fees. This is why even legendary investor Warren Buffett recommends index funds for most investors.
How to Start Index Fund Investing
Step 1: Choose Your Account Type
Decide where you want to invest. Options include:
- 401(k) or 403(b): Employer-sponsored retirement accounts with tax benefits
- IRA: Individual retirement accounts (Traditional or Roth)
- Taxable brokerage account: Flexible accounts with no contribution limits
Step 2: Select Your Index Funds
A simple three-fund portfolio covers most investors needs:
- US Total Stock Market Index Fund (60-80%)
- International Stock Index Fund (10-20%)
- Total Bond Market Index Fund (10-30%)
Step 3: Set Up Automatic Investments
Automate your contributions to invest consistently regardless of market conditions. This strategy, called dollar-cost averaging, helps you buy more shares when prices are low and fewer when prices are high.
Example: Dollar-Cost Averaging
You invest $500 monthly into an S&P 500 index fund:
- Month 1: Price is $50, you buy 10 shares
- Month 2: Price drops to $40, you buy 12.5 shares
- Month 3: Price rises to $55, you buy 9.1 shares
After 3 months, you own 31.6 shares at an average cost of $47.47 per share, lower than the ending price.
Common Index Fund Mistakes to Avoid
- Checking your portfolio too often: Daily fluctuations are noise. Focus on years, not days
- Trying to time the market: Stay invested. Time in the market beats timing the market
- Paying high fees: Always compare expense ratios. A 1% difference costs you tens of thousands over time
- Not diversifying enough: Do not put all your money in one sector or country
- Panic selling during downturns: Market drops are normal and temporary. Stay the course
Index Funds vs ETFs
Both index mutual funds and index ETFs track the same indexes, but they have some differences:
- ETFs: Trade like stocks throughout the day. Often have lower minimum investments. May have slightly lower expense ratios
- Mutual Funds: Trade once per day at closing price. Easier to set up automatic investments. No trading commissions at most brokers
For most long-term investors, both options work well. Choose whichever fits your investment style better.
Track Your Index Fund Portfolio
Pro Trader Dashboard helps you monitor your index fund investments alongside your other holdings. See your asset allocation, track performance over time, and stay on top of your wealth-building journey.
Summary
Index fund investing is one of the simplest and most effective ways to build long-term wealth. By owning a diversified portfolio of low-cost index funds and investing consistently over time, you can participate in the growth of the entire economy without the stress of picking individual stocks.
The key principles are simple: start early, keep costs low, diversify broadly, and stay invested through market ups and downs. Your future self will thank you for starting today.
Ready to explore more investment strategies? Learn about factor investing or discover how smart beta ETFs work.