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How to Invest in Index Funds

Knowing how to invest in stocks is an important step you can take to achieve financial freedom. It’s a statement backed by TONS of research.

The best way to invest in stocks is through index funds. I am not the only one saying that. It’s also recommended by billionaire investors:

  • “When you look at the results on an after-fee, after-tax basis, over reasonably long periods of time, there’s almost no chance that you end up beating the index fund.” – David Swenson
  • “Both large and small investors should stick with low-cost index funds.” – Warren Buffet

What is an Index Fund and How Does It Work

Successfully choosing individual stocks is difficult. Even people who have studied them for all their lives find it tough and can’t beat the market. That’s where index funds come in.

They may seem boring, but they tick all the boxes that a good investment should have.

  • Lowest costs? Yes.
  • Maximum returns? Yes.
  • Minimum taxes? Yes.
  • No effort? Yes.

An index is quite simply a basket of securities within an asset.

For example, the S&P 500 is a collection of the 500 biggest companies in the US. It’s a common market benchmark that lots of investors try to match. If you were building a portfolio from scratch, you’d have to buy shares in all 500 companies in order to match the market. Or you could buy one share in an index fund which matches the market for you. You get all the benefits without any of the work. The same principle works across any index fund for different assets like US stocks, international stocks, bonds, real estate, and even commodities.

An index fund aims to mimic an index. The fund managers invest in securities in the same proportion as they are found in the market.

Index funds are passive in nature. Their fund managers don’t keep buying and selling stocks to “beat the market”. In fact, their objective is to be the market.

Even if a few stocks in an index don’t perform well, the others will protect your portfolio. An index fund lets you own the entire market. Yes, that’s right. By buying JUST ONE index fund, you can invest in ALL of America’s biggest companies.

On the other hand, in actively managed funds, money managers use their judgment to invest in stocks that they believe will grow the most. But, as you know, that’s a difficult job to do. That’s why index funds perform better than actively managed funds 90% of the time.

Index funds are low-cost because they don’t charge you for BS like the fund manager’s fee and admin costs. Their job is a lot easier. They don’t need to do a bunch of fancy analysis to beat the market, they simply follow the market wherever it goes. An average index fund costs less than 0.20%. In comparison, actively managed funds have an average cost of 0.60%. The high fees also lower your returns. Why would you pay a higher fee for a lower performance?

By buying expensive mutual funds, you are securing your financial advisor’s retirement, not yours. At the same time, constantly buying and selling stocks also increases taxes, lowering your returns further.

Because of all these reasons, I recommend putting 90% of your stock investments into index funds.

So which index funds should you buy?

The Best Index Funds to Choose From

There are hundreds of indexes across the world and even more index funds. But there’s a few standouts that you should consider.

I’ve broken the most popular options down by asset class:

US Stocks

Vanguard 500 Index Fund Admiral Shares (VFIAX): This is my personal favorite. It tracks the S&P 500. Vanguard is the pioneer of index funds, and its founder, Jack Boggle, is a legendary American investor.

Expense ratio: 0.04% and Minimum Investment: $3,000.

The Schwab’s S&P 500 Index Fund (SWPPX) or the Fidelity 500 Index Fund (FXAIX) are also reputed funds. Both have no minimum investment requirements.

The Vanguard Total Stock Market Index (VTSMX): I also like this fund because it represents not just the biggest companies in the US, but also the smaller ones. It aims to track 100% of the investable stocks in the US. It’s a perfect option if you want a US stock index fund.

Expense Ratio: 0.14% and Minimum Investment: $3,000.

US Bonds

Bonds are like an IOU by governments or corporations. Most are very low risk. That’s why their returns are lower, but they make your portfolio less risky. My suggestion? The Vanguard Total Bond Market ETF (BND). It invests in both US government and corporate bonds.

Expense Ratio: 0.035% and Minimum Investment: $3,000

Real Estate Investment Trusts (REITs)

Think of REITs as index funds for real estate. They pool money from investors to buy income-producing real estate such as domestic and international housing, industries, and commercial properties.

They are great investments for those who don’t want to have the headache of buying physical real estate but still invest in it. I love the Vanguard REIT ETF (VNQ). It’s solid and reputable.

Expense ratio: 0.12% and Minimum Investment: $3,000

International Stocks and Bonds

International stocks and bonds diversify your portfolio. International stocks don’t typically correlate with the performance of US stocks. When one has a good year, the other usually doesn’t. By investing in both, you smooth out your returns by investing in multiple asset classes that don’t correlate with each other.

Here’s a real-life example of the benefits of diversifying in international stocks. From 1976-2010, a portfolio that had 60% US stocks and 40% international stocks would have given marginally higher returns but at a lower risk than a portfolio with 100% US stocks.

I like the Schwab International Index Fund (SWISX). It invests in several countries and is extremely affordable.

Expense Ratio: 0.06% and No Minimum Investment.

For international bonds, my choice is the Vanguard Total International Bond Index Fund Admiral Shares (VTABX).

Expense Ratio: 0.09% and Minimum Investment: $3,000.

Best Options for Buying Index Funds

If you haven’t already done it, the best way to begin investing in index funds is through your 401(k) and Roth IRA accounts. You should absolutely max out both because they help you save out on truckloads of taxes. Speak to someone at HR at your employer and set up an investment plan into index funds for your 401(k). Watch the fees though, some 401(k) plans only give you access to horrible mutual funds.

You will need a broker to invest in index funds through your Roth IRA. A good broker must be low-cost, secure, and easy to use.

My favorite inline brokers are TD Ameritrade, Vanguard, and Fidelity.

Signing up with these brokers is easy. Here’s a quick guide on how to go about it:

  1. Go to the brokerage website of your choice.
  2. Click on the ‘Open An Account’ button.
  3. You need to apply for an ‘Individual Brokerage Account’.
  4. Fill in all the relevant information about yourself.
  5. You need to transfer the initial deposit at this stage if your broker requires it.
  6. Sit back and wait. Verifying your information might take anywhere between 3 to 7 days.
  7. The broker will get in touch with you once your account is setup. All that is left now is buying your first index fund. At this stage, it is as easy as buying something from Amazon. Look up the fund you want and place an order.

Considerations and Tips Before Investing Into an Index Fund

Now, I know you may be wondering how you can tell a good index fund from a bad one. Here are some things you should keep in mind while investing in index funds:

Costs: Traditionally, index funds are low cost (under 0.20%). But some of them are crazy expensive and cost more than 1.5%. You know what to do in this case. STAY AWAY from them. As a thumb rule, do not invest in index funds that cost more than 0.20%.

Tracking: The sole job of an index fund portfolio is to mimic an index accurately. To ensure this is happening, compare the holdings and returns of the concerned index to your fund. I don’t worry about this with major online brokers like Vanguard or Fidelity but if you’re investing into a smaller broker, check their returns and make sure they’re matching their benchmark as expected.

Checking investments every day: Do NOT do this. You are better of watching cat videos on Instagram. Believe me. Looking at your investments every day has not helped anyone. Check your investments once every three months. Index funds are the safest and best way to invest in stocks. Take advantage of it and don’t get worried with day to day drops.

Automation: Investing once a year is like exercising only once a year. It’s clearly not going to solve the purpose. You need to be consistent with your investments. So, make sure you set up an automatic monthly investment into index funds.

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