Index funds are one of the simplest and most effective ways to build wealth over time. They require very little knowledge to get started, cost almost nothing to own, and have beaten the majority of professional money managers over the long run. Here is exactly how to buy your first one.
What Is an Index Fund?
An index fund is a type of investment that tracks a specific market index, such as the S&P 500. The S&P 500 is a list of the 500 largest publicly traded companies in the United States. When you buy a fund that tracks it, you own a tiny slice of all 500 companies at once.
The key word is “tracks.” An index fund does not try to pick winning stocks. It simply buys everything in the index in proportion to each company’s size. This is called passive investing, as opposed to active investing where a fund manager picks stocks.
Because index funds do not require active management, their fees are extremely low. The annual cost of owning many index funds is less than 0.10 percent of your investment per year. That is a dollar per year for every $1,000 invested.
Why Index Funds Work
Decades of research show that most actively managed funds underperform their benchmark index over long periods of time. After accounting for fees, the average actively managed fund loses to the index it is trying to beat.
Index funds win because they have lower costs, lower turnover, and better tax efficiency. When a fund manager trades frequently, it generates taxable gains and fees. An index fund trades infrequently because it only changes when the index changes.
Warren Buffett has publicly recommended low-cost index funds for most individual investors. He has said the S&P 500 index fund is the best investment most people can make.
Types of Index Funds
Mutual Fund Index Funds
These are traditional mutual funds that track an index. You buy them directly from a fund company like Vanguard or Fidelity. They price once per day after the market closes. Minimum investment amounts vary but are often between $1 and $3,000.
Index ETFs (Exchange-Traded Funds)
Index ETFs work the same way but trade on a stock exchange throughout the day, just like a stock. You can buy a single share, which makes them accessible with very little money. Many brokerages now offer fractional shares, so you can invest any dollar amount.
For most beginners, index ETFs are the easiest entry point because there are no minimums and they are available at every major brokerage.
The Most Popular Index Funds
The most widely held index funds track the S&P 500. The three most popular are:
- Vanguard S&P 500 ETF (VOO) — expense ratio 0.03%
- Fidelity 500 Index Fund (FXAIX) — expense ratio 0.015%
- iShares Core S&P 500 ETF (IVV) — expense ratio 0.03%
- SPDR S&P 500 ETF Trust (SPY) — expense ratio 0.095%
Any of these will give you nearly identical results. The differences between them are negligible for most investors. Pick whichever is available at your brokerage.
Beyond S&P 500 funds, other common index fund types include total stock market funds (which include small and mid-size companies too), international index funds, and bond index funds.
Step-by-Step: How to Buy an Index Fund
Step 1: Choose a Brokerage
You need a brokerage account to buy index funds. The best options for beginners are Fidelity, Vanguard, and Charles Schwab. All three offer no-commission trades and no account minimums. Fidelity and Schwab are often recommended as starting points because their interfaces are user-friendly.
Step 2: Open and Fund the Account
Opening an account takes about 10 minutes online. You will need your Social Security number, bank account information, and a government-issued ID. Link your bank account and transfer money in. The funds typically arrive in 1 to 3 business days.
Step 3: Decide Which Account Type
You can hold index funds in a taxable brokerage account or a tax-advantaged account like a Roth IRA or traditional IRA. If you have not maxed out your IRA for the year, starting there is usually better because your gains grow tax-free or tax-deferred.
Step 4: Search for the Fund and Buy
In your brokerage account, search for the ticker symbol of the fund you want, such as VOO or FXAIX. Enter the dollar amount you want to invest and place a market order. For ETFs, your order executes during trading hours. For mutual funds, it executes at end of day.
How Much to Invest
There is no minimum required to get started with many index ETFs. The question is how much you can afford to invest regularly. Even small amounts grow significantly over decades due to compound growth.
A common approach is to invest a fixed dollar amount each month regardless of what the market is doing. This is called dollar-cost averaging and removes the pressure of trying to time the market.
What to Expect After You Invest
Index fund values go up and down with the market. Some years you will see gains of 20 to 30 percent. Other years you will see losses of 20 to 30 percent. This is normal. The key is not to sell during downturns.
Over long periods, the U.S. stock market has historically returned about 7 percent per year after inflation. This is not guaranteed, but the long-run trend for decades has been upward.
Reinvest dividends. Most brokerages let you set dividend reinvestment automatically. This means any dividends paid by the fund are immediately used to buy more shares, compounding your growth without any action on your part.
Common Mistakes to Avoid
- Checking your account too often: Watching daily fluctuations leads to panic selling at exactly the wrong time.
- Waiting for the “right time” to invest: Time in the market beats timing the market. Start as soon as you can.
- Owning too many funds: Buying five different S&P 500 funds does not diversify you. You end up with the same holdings, just spread across more accounts.
- Paying high expense ratios: Always check the expense ratio before buying. Anything above 0.5% annually is too high for a passive index fund.