5-Step Beginner's Guide to Investing in Index Funds
As seen in Business Insider on September 22, 2021
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.
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