5-step beginner's guide to investing in index funds

Table of Contents: Masthead Sticky

• Index funds are a type of investment vehicle that strive to match the returns of a particular market index.
• Investing in index funds can help investors diversify their portfolio and be a low-cost way to build wealth.
• There are many different indexes to choose from that reach a wide variety of sectors and markets.

Index funds are recommended by billionaire Warren Buffett and are often touted as one of the most popular ways to reach FIRE (Financial Independence, Retire Early). Index funds are a type of investment vehicle such as a mutual fund or exchange-traded fund (ETF) that works to achieve similar results as those on specific indexes (hence, the name) such as the S&P 500.

If you want to follow suit, here's how to invest in index funds.

Step 1: Review your finances and goals

Before investing, it's important to get clear on your personal situation and life goals. When do you want to retire and how far away are you from that milestone? And what does your risk tolerance and budget look like? Understanding all of this will help you understand the role index funds will play in your life and how to invest in them.

Knowing how much to invest requires you to take inventory of just how much money you can afford to invest. Review your finances and answer these questions to help you assess how much you can afford to invest:

• What is your current after-tax income - in other words, your take-home pay?
• What are your current expenses?
• How much debt do you have and what are your monthly payments?
• What is your net worth? (This is your assets minus liabilities.)

Answering these questions will give you a big picture view of your finances and give you insight into how much you can invest. Knowing your goals will help give your money a job and keep you motivated.

It's important to note that risk is part of investing and can't be completely avoided. But there are ways to invest within your comfort levels, by first identifying your risk tolerance. Risk tolerance refers to your comfort level and how much you're willing to lose with your investments. You can take this risk tolerance quiz from Rutgers to see where you're at.

Step 2: Choose an index

Index funds are a class of ETFs or mutual funds that are designed to emulate the performance of a particular market index.

"Index funds generally benefit an investor by providing diversification and relatively low fees compared to actively managed funds. Index funds are designed to track and follow a broad sector such as large caps, emerging markets, broad indexes like the S&P 500, or it can even be as specific as tracking large technology companies, for instance," explains Julian Schubach, an independent investment advisor and vice president of wealth management at ODI Financial.

There are many different types of indexes, all of which serve different purposes. Because of the nature of index funds, they are inherently diversified. For example, the S&P 500 (which refers to Standard and Poor's 500) is just one of many major indexes which tracks the top 500 publicly traded companies.

Some other major indexes include:

• Nasdaq-100 Index, which tracks the top 100 securities traded on The Nasdaq Stock Market
• Dow Jones Industrial Average (DJIA), which is an index that contains 30 blue chip stocks from various US companies
• NYSE Composite Exchange, which tracks price fluctuations among stocks listed on the New York Stock Exchange
• Wilshire 5000 Total Market Index, which tracks the performance of the entire stock market with U.S.-based securities
• Russell 2000 Index, which tracks the performance of the 2,000 smallest publicly-traded companies in the US

When thinking about what index to invest in, consider the following:

• Type of industry. Every dollar you spend or invest can be used as a vote to support something based on your values. For example, if you want to support the environment, you might focus on clean-energy index funds. If you're interested in tech or even supporting women-led companies, there are index funds for that.

• Risk tolerance. You can review past performance and assess your risk tolerance before choosing a specific index - although, as noted above, index funds can be considered less risky as they're diversified. For example, large cap indexes may have higher levels of risk, and if you want lower levels of risk, you can look at specific bond indexes.
• Opportunities for growth. Are there up-and-coming investment sectors where you might want to put your money?
• Funds that trade based on a specific location. For example, index funds that trade on the foreign exchange.
• The company size and market capitalization. For example, small cap, mid cap, and large cap all refer to the size of a company as well as the company's market capitalization.
• Types of assets the index funds track. The index fund can track certain commodities, stocks, or bonds.

Taking all of this into consideration can help you identify which index can best match your goals.

Quick tip: You can review other indexes and get additional information from the Federal Reserve Bank of St. Louis.

Step 3: Decide which index funds to invest in

Now it's time to decide which index funds you want to invest in.

"Each fund and fund company may have different fees and portfolio construction, though, so it is important to research the differences between each offering within a broad index," explains Schubach. "A good way to start is to research the assets under management (AUM) of a given index fund, the fee structure, the ease of trading and access to the fund, and the background of the managers in charge of the given fund."

Index funds at different companies can have similar goals but have different short- and long-term costs to consider.

Review any opening account minimums or investment minimums in a certain index fund. For example, the popular Vanguard Total Stock Market Index Fund Admiral Shares (VTSAX) has an investment minimum of $3,000.

Two other major costs to consider when investing in index funds are the tax-cost ratio, which refers to the amount of taxes you pay based on distributions compared to your returns, as well as the expense ratio, which includes all fees related to managing the fund. These costs and related fees can take a chunk of your wealth without you realizing it. You want to look for low expense ratios, typically below 1% as a benchmark.

Step 4: Open a brokerage account and buy index fund shares

If you want to learn how to invest in index funds, you'll want to choose an investing strategy and go from there. For example, do you want to DIY it or have professional help? Your answer will determine what type of investment account you'll need to purchase index fund shares.

"Investors first must decide if they want to pick the index funds themselves and manage the allocations directly. If the investor feels this is the best route for them, they can establish an investment account at any of the numerous brokerage platforms such as Fidelity, TD Ameritrade, Charles Schwab, or even app-based platforms such as Robinhood," notes Schubach. "In this scenario, the investor would research the universe of index funds available and purchase the funds they'd like to own."

You can do this by:

• Opening an online brokerage account. You could open an account with brokerages such as Fidelity or Vanguard to manually invest in funds yourself.
• Using a robo-advisor. You could also use a robo-advisor such as Betterment and Wealthfront which do much of the heavy lifting for you, by investing and rebalancing automatically.

"For those who wish to invest in index funds, but prefer some help, they can work with a financial advisor who can help guide them to the funds which best match their risk tolerance, and they would subsequently manage those funds for the investor," says Schubach.

In this scenario, you can work with an investment professional who can help guide you through the process. This option may be more costly.

Regardless of your investment options, here are some things you want to keep in mind when choosing a brokerage.

• What type of fund selection do they offer?
• How convenient is it to use the platform? Do they have a mobile app and is the user experience good?
• How much does it cost to trade? You can review the expense ratios in the prospectus and see if there are commission-free trading options.

The key is to have a strategy that works for you, while also minimizing costs.

Quick tip: If you have an employer-sponsored retirement plan like a 401(k), you may also be able to invest in index funds through there as well.

Step 5: Continue to manage your investments

Once you've started investing in index funds you want to do two things:

1. Continue to invest regularly. This may mean setting up automatic monthly contributions or setting a schedule when you add more money to your portfolio.

2. Check in regularly with your investments. Consider checking in on your investments at least once a year. You can also consider checking in quarterly. Many index funds rebalance on their own, but it's a good idea to check that your funds are still in alignment with your portfolio's goals.

The financial takeaway

Investing in index funds can be a great way to diversify your portfolio without taking on so much risk. It's also a way to tap various markets across different sectors and support certain industries with your investments.

To get started, follow these steps to invest in index funds and be aware of your short- and long-term goals while keeping an eye on total costs.

What's the difference between ETFs and index funds?Index funds vs. mutual funds: What's the difference?Understanding what financial advisors do and how they help clients better manage their moneyWhat is a broker? What to know about the intermediary that helps investors buy stocks