A Beginner’s Guide to Index Funds

A Beginner's Guide to Index FundsIf you have more than a few months of savings in a checking or savings account (and have a pretty stable situation), you should consider investing your money. Once you have an emergency fund saved up, it’s time to put your money to work. Your money should earn money, and the best way to do that is investing.

You may be a novice, but by now you should know the basics of investing. The best part about investing these days is that you don’t need to be an expert. In fact, you don’t even need to know what you’re doing, because there are systems in place that can take care of everything for you. I’m someone who is constantly plugged in to Wall Street, and yet I still rarely pick stocks. Why? Because I like diversity, and why invest in one stock when I can invest in hundreds? This is exactly where index funds become our best friend

If the stock market bewilders you, don’t feel bad. Understanding the inner workings of the market takes dedicated study and constant attention and it’s not for everyone. We don’t need to pretend that we’re better at picking stocks than someone who spends all day researching. Most people don’t have the time or money to make consistently profitable decisions on individual stocks; index funds exist for that very reason.

What is an Index Fund?

To better define an index fund, it’s important to know what both an “index” and “fund” are within the context of the stock market. A stock market index is the valuation of an individual section of the stock market based on the prices of certain selected stocks. Unlike a mutual fund, which is comprised of stocks selected by a human person (or group of people), an index fund is managed automatically by computer. There are global indices, national indices, and indices that track specific market sectors. You may have heard of the S&P 500 or Russell 1000. These are examples of index funds that contain (you guessed it) 500 and 1000 stocks, respectively.

A fund is simply a large repository of capital that belongs to many investors and is used to purchase stock. This arrangement gives individual investors more opportunities to diversify their investments. If you buy one stock and it doesn’t do well, you could be out a significant amount of money. But if you spread your money throughout many stocks, you’re spreading out your risk. The likelihood of many stocks tanking is much lower than the likelihood of just one stock decreasing a lot.

Index Funds vs. Mutual Funds

So, if an index fund is run by a computer and a mutual fund is run by a person, which one is better?

With an index fund, the goal is to match the performance of the index. If the index increases by 6% in a year, the index fund should increase by 6%, too.

With an actively managed mutual fund, there’s the chance to beat the market. But pound for pound, index funds have a reputation for outperforming managed funds over-time. On top of this, index funds allow you to succeed on the stock market with virtually zero experience. In addition, index funds usually have super low fees (as low as 0.05%), while mutual fund fees regularly exceed 1%.

The Benefits of an Index Fund

Warren Buffett, the world’s most famous investor said it himself: “Just making monthly investments in a low-cost index fund makes a lot of sense.” Why? Because “Owning a piece of America, a diversified piece, bought over time, held for 30 or 40 years, it’s bound to do well. The income will go up over the years, and there’s really nothing to worry about.” In fewer words: keep it simple, stupid. Quite often, the easiest approach is the best approach, especially for the beginning investor.

Where to Get Started

Getting started with your first index fund is designed to be easy. Take a look at some of the more popular index funds, like the Vanguard 500 or Fidelity Spartan 500 and you’ll find that both the risk and the barrier to entry are very low.

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