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Are you tired of hearing about the latest “hot” stock pick or a new investment trend that eventually just fades away?
Depending on your financial goals, investing your money in the stock market could be a wise decision to make.
A lot of people want to learn more, but investing is overwhelming. I get it. It’s something that school never taught us.
What if there was a way to invest your money that was simple, low-cost, and had a proven track record of success?
Enter index funds!
These often overlooked investment vehicles have become increasingly popular among beginner and experienced investors.
And, for good reason too.
In this ultimate beginner’s guide to index funds, we’ll explore everything you need to know about the subject. We’ll go over what they are, why they make great investments, how you can start investing, and much more.
So, buckle up, and get ready to unlock the secrets of successful investing with index funds!
What is an index fund?
Index funds are a type of investment that tracks the performance of a specific group of stocks or bonds, otherwise known as an index.
Unlike actively managed mutual funds that try to outperform the market, index funds simply mimic the performance of the index.
Think of it like a basket full of stocks or bonds. Buy the basket, and you’ll invest in all the companies within the basket.
By investing in an index fund, you get exposure to a broad range of businesses, which can help reduce risk, and in turn, improve your return on investment over the long term.
Let’s take the S&P 500 as an example. The S&P 500 is a stock market index that tracks the top 500 publicly-traded companies in the United States.
If you wanted to invest in the top 500 companies in the U.S., all you would have to do is invest in an S&P 500 index fund.
Invest in the index fund, and you invest in all 500 companies.
Types of Index Funds
There are several types of index funds available, each with its unique characteristics.
Here are some of the most common types of funds grouped into four different groups.
- Domestic Equity Index Funds: These index funds track the performance of a domestic stock market indexes, such as the S&P 500, the Dow Jones, or the Nasdaq.
- Bond Index Funds: They track the performance bonds which are fixed-income securities. Bonds are usually less volatile than equity index funds. They provide a low, but steady stream of monthly income.
- International Equity Index Funds: These types of index funds invest in stocks or bonds outside of the United States. They provide diversification across international borders and can be broken down into the following two groups:
- Developed Markets: Businesses with their headquarters located within developed nations such as Germany, the U.K., Switzerland, and Japan.
- Emerging Markets: Businesses with their headquarters located within developing nations such as Brazil, South Africa, and India.
- Sector Index Funds: Provide exposure to specific sectors of the economy, such as technology or healthcare. These funds can provide targeted exposure to a particular industry.
Why should I invest in index funds?
There are many reasons why you should invest in index funds. Contrary to popular belief, index funds are one of the best things you can invest in.
I have a whole blog post that compares the pros and cons of index funds, but here are some pros to name a few:
- Low Fees: One of the most significant advantages of index funds is their low fees. Because index funds are passively managed, they don’t need a team of expensive experts to make investment decisions. Fees are much lower because all the fund manager has to do is replicate the index.
- Diversification: Index funds offer great diversification because they invest in a broad range of stocks from different sectors. If a single stock goes out of business, the fund will remain afloat from the other stocks.
- Tax-efficient: As I mentioned earlier, index funds are passively managed, which means they don’t require the constant buying and selling of stocks. The average index fund has a turnover rate of only 2%. This makes them highly tax-efficient, and a set-and-forget type of investment. You won’t have to constantly monitor your portfolio.
- Proven Track Record: Over the long term, index funds have performed very well. They have historically recovered from all recessions and economic downturns. The S&P 500 Index Fund has had an average yearly return of 10% since its inception.
How to invest in index funds
Now that you have a good idea as to why index funds make great investments, we’ll break down how you can start investing in one today.
Investing in index funds is a pretty straightforward process – it can be done by following a few simple steps.
1. Determine your investment goals
Before you start investing, it’s important to have a clear understanding of your financial goals.
To determine your financial goals, you can ask yourself questions like:
- How much risk am I willing to take?
- How long am I investing for?
- How much can I invest and how frequently?
If you’re willing to take on more risk and invest for a longer period, you may be able to invest more in a stock index fund such as FXAIX.
Stocks are generally more volatile and riskier than bonds but yield a higher return on investment.
If you’re more risk-averse, you can allocate a higher percentage of your portfolio to a bond index fund such as FXNAX.
2. Open an investment account
The next step will be to open a brokerage account.
A brokerage firm provides intermediary services by making matches between buyers and sellers of stocks, bonds, and other financial assets.
They’re like the middleman between you and the stock market.
There are many reputable online brokerages to choose from. These days, most offer extremely low fees, awesome customer service, and user-friendly platforms.
Three of the largest brokerage firms that exist are:
You can’t go wrong with any of these.
3. Chose your index funds
Once you have your brokerage account, it’s time to choose your index funds.
There are so many different types of index funds to choose from, such as funds that track broad market indices like the S&P 500, as well as more niche indices like renewable energy or technology.
You must evaluate your financial goals and do research before investing in anything.
For the average beginner, I recommend sticking to broader market index funds. This will provide ample exposure to many different businesses and sectors while reducing the risk of losing money.
For example, you could invest in an S&P 500 Index Fund for domestic equity and an international index fund for international equity.
Then, you need to determine your asset allocation.
In other words, “how much percentage of your portfolio are you going to allocate to each fund?”
A popular allocation is 60% domestic and 40% international, but do what fits your goals.
4. Determine your investment amount
After you’ve chosen which index funds you want to invest in, it’s time to determine how much you’re going to invest.
Some brokerages like Vanguard require a minimum initial investment amount while others like Fidelity and Schwab do not.
To determine how much you’re going to invest, you need to look back at the investment goal you created earlier.
- How many years are you going to invest?
- How much money do you want to have at the end of your investing journey?
- How frequently are you going to invest? Once a month? Once a quarter?
These are all great questions to ask yourself when determining how much you’re going to invest.
Important >> Investing costs money. If you’re having trouble saving money, my two articles on saving money on a low income and 11 unique money-saving tips will be super helpful!
Index Funds vs. Actively-managed mutual funds
No matter what you invest in, it’s always important to look at the performance.
Index funds have a proven track record of delivering solid long-term returns.
While the performance of individual index funds may vary from one another, index funds generally have consistently outperformed actively managed mutual funds.
The first reason why index funds outperform is because of their low costs.
Actively managed funds have much higher fees and expenses. Although a certain fund may achieve superior returns, those returns would get eaten up by the fees.
On the other hand, index funds are passively managed and don’t require the same level of active management or research. This in turn lowers the overall expenses of the fund.
Lower expenses translate to a higher net return, which results in better long-term performance.
The second reason why index funds outperform is because of little room for error.
“Actively managed” literally means that the fund manager is using his expertise and best judgment to choose the best stocks to invest in.
Not to doubt anyone’s abilities, but fund managers are human and they make mistakes too, including choosing the wrong picks and poor market timing.
An index fund tracks its index, and that’s all it does. This leaves pretty much no room for error.
As a result, index funds can deliver consistent and predictable returns.
Lastly, index funds provide better diversification.
Because index funds track a broad market index, they provide exposure to a large number of stocks across different industries and sectors.
Diversification reduces the impact of any single stock’s poor performance on the overall portfolio.
On the other hand, actively managed funds may focus on specific sectors or industries, which can increase the risk of underperformance or volatility.
Therefore, this makes index funds a superior and safer option.
Index Funds vs. Other Investments
When it comes to investing, there are a variety of different options available to investors.
Some options include individual stocks, bonds, and real estate.
Each of these investments has its unique characteristics, and we’re going to see how they compare to index funds.
Index Funds vs. Real Estate
Real estate has long been considered a popular investment, but it comes with significant upfront capital requirements and ongoing maintenance costs.
While investing in real estate can lead to substantial returns and a passive income stream, it also requires a lot of research and due diligence to find the right property to invest in.
On the other hand, index funds are pretty much a hands-off investment that is low-cost and low-maintenance.
An index fund won’t bother you at 4 am because the toilet isn’t working.
If you want to get exposure to real estate but don’t want to own physical properties, you can consider investing in REITs.
REITs, or real estate investment trusts, are companies that own and operate physical properties such as office buildings, shopping malls, apartments, hotels, and warehouses.
By investing in a REIT index fund, you get to invest in a variety of companies that own real estate.
While returns from REIT index funds may not be as high as owning physical properties, they provide diversification and liquidity which is nearly impossible to achieve by directly owning real estate.
Index Funds vs. Individual Stocks
Investing in individual stocks is an exciting experience.
As long as you’re willing to put in the hours to research, analyze, and study the trends of the market, individual stocks can offer remarkable returns.
However, you need to be careful with individual stocks as they’re higher-risk investments. Even with careful research, poor asset allocation and market volatility could cause you to lose money.
Index funds may not be able to provide the same high returns as stocks, but they’re much more stable. For example, an S&P 500 index fund would yield an average of 10% per year.
Index funds hold shares in many different companies, which reduces the risk of underperformance and volatility in any single stock.
Read More >> Are Index Funds Better Than Stocks?
Index Funds vs. Bonds
Bonds are fixed-income investments that provide a consistent stream of income for a set period.
They’re generally less risky compared to stocks. While stock investors aim for capital growth, bond investors aim for capital preservation.
Because bonds are less risky than stocks, they offer a lower return on investment. While the stock market averages around 10% per year, bonds often yield around 2-3%.
People who are invested in bonds are generally those who are nearing retirement or those who are in retirement.
Because they’re living off of their investments, they can’t afford to risk money in the stock market, and therefore, seek to preserve their capital by investing in bonds.
Conclusion
Index funds are a fantastic tool for anyone looking to achieve long-term capital growth.
With low fees, diversification, and consistent returns over time, index funds can provide you with peace of mind and a sense of security.
It’s always important to remember the risks involved in anything you invest in, and index funds are no exception.
There will be times when the market goes through a correction or a recession. But keep in mind that you’re investing for the long term, and you’ll come out on top as compound interest works in your favor.
I hope you enjoyed this post on index funds, let me know what you think in the comments below!
Read More >> Want to learn how to build a portfolio and an investing strategy with index funds? Check out my article on the 3-fund portfolio strategy.
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