Welcome to our Beginner’s Guide to Index Funds
Index funds are your secret weapon in the fight for financial independence.
However, they can be daunting!
If you want to start investing in index funds but need a little push…
You’re in the right place.
Let’s dive right into our beginners guide to index funds.
A Guide To Index Funds
An Introduction To Index Funds
Investing can be overwhelming, especially when you try to invest in stocks individually.
Despite this, it sometimes feels like everybody (except you) is a successful stock trader. Especially with the introduction of consumer investment apps like eToro.
Remember though, with every person who makes a profit trading stocks, 9 people make a loss!
That’s the part your friends aren’t telling you.
If you’re a new investor, make it easier for yourself and consider investing in index funds.
This passive investment diversifies your investment and provides conservative returns that reduce the risk of taking a loss.
They’re also easier, less time consuming and can be much lower risk.
Interested? Keep reading for our beginners guide to index funds. We’ve included everything a beginner needs to know about index funds – so it’s pretty thorough!
Still tempted by individual stocks and shares?
Learn how to make money in the stock market.
What Are Index Funds?
Let’s start with a clear definition of an index fund.
Index funds are mutual funds or exchange traded funds (ETF’s) made of investments meant to match a specific market index, such as the S&P 500. They don’t try to beat the market. Instead, they try to match its returns.
What does all this actually mean?
In layman’s terms, investing in an index fund means you’ll own shares in lots of different companies.
If one (e.g. Apple) was to plummet, your losses would be offset by your other companies.
Index funds therefore give your portfolio the necessary diversification to offset a total loss.
You could (hopefully) therefore still be in profit, despite some companies losing value.
How many companies are included in one index fund?
A single Index fund may include hundreds of companies. These are pre-chosen and mapped to a market index*. All you need to do is choose your preferred index fund.
Other benefits of an index fund?
Index Funds also offer a low expense ratio. They have minimal portfolio turnover (less buying and selling) than other investments, which further decreases your expenses.
This is another reason index funds can be great for beginners.
How Do Index Funds Work?
Investing in index funds is generally a passive investment.
This is also known as “set it and forget it” investing.
Basically, once you’ve chosen your index fund and arranged a monthly deposit – it’s completely passive. Simply ignore the charts (easy for me to say) and your funds will hopefully grow over time.
When setting up a passive index fund, managers invest in the securities that make up the chosen index and leave it alone – they don’t buy and sell.
When you invest in an index fund, you buy shares from the fund manager who bought shares of every stock in a chosen index. Your value then mimics the value of an index, such as the S&P 500.
Conversely, traditional mutual funds have a portfolio manager actively buying and selling investments daily. This adds management costs and the additional risk of human error (the fund manager may underperform).
What's The Difference Between Active And Passive Funds?
You may be asking why anyone would choose active over passive?
It all comes down to risk vs reward profile.
Active funds are trying to beat the index fund and if successful, may have much higher returns.
However for the same reasons, they usually have a higher risk of incurring losses.
The decision is yours to make.
As this is a beginners guide to index funds I would advise caution when starting out. A low-medium risk passive fund is the sweet spot for most people.
Who Should Invest In Index Funds?
Wondering, should I invest in index funds?
If you want to invest in the stock market but don’t want to deal with its intense ups and downs, index funds can be a happy medium.
By essentially investing in every security within an index, you’re setting up a completely diversified portfolio.
Aim to earn a steady return rather than facing extremely bullish and bearish markets. Slow and steady wins the race.
For example, if you previously invested in an S&P 500 index fund, you’d have seen a 10% average annual return (13.6% for the last 10 years!).
This demonstrates the magic of compound interest (earning interest on your interest).
The profit can soon add up!
For this reason, Index funds should be thought of as a long-term investment.
The accepted wisdom to hold the fund for a minimum of 5-years… However ideally you should think of it as a retirement fund.
Relying on withdrawing too soon risks being forced to withdraw during a market dip or bad year. When investing longer term, brief dips are of no concern.
More time in the market also means more compound interest. Try our early retirement calculator to see this in action.
Who Shouldn't Invest In Index Funds?
If you’re looking for crazy high returns or to buy and sell securities often, you shouldn’t invest in index funds.
They are really for passive investors wanting a conservative approach to investing in the market.
Equally if you’re looking for a get-rich-quick investment, Index funds aren’t it!
A sensible approach might be a combination of investment strategies. A large percentage of your portfolio in index funds, with a smaller weighting into high risk/high reward strategies. (This is of course however, just an opinion)>
Have a think about your own appetite for risk and start to develop your own strategy.
Does Warren Buffet Invest In Index Funds?
OK, this sounds like a slightly odd question.
After all, this is a beginners guide to index funds and Warren Buffet isn’t exactly a beginner. Why would Warren Buffet, one of the worlds most successful investors, invest in index funds?
Well… because they work.
As you can see, Mr Buffet is a strong advocate of beginners investing in index funds.
Additionally, he has publicly declared that he plans to invest 90% of his massive estate into index funds. Of course, this is after a lifetime of trading individual stocks and shares.
However, if index funds are good enough for Buffet, they’re good enough for me!
Is It A Good Idea To Invest In Index Funds?
Whether it’s a good idea to invest in index funds or not depends on your strategy.
If you’re looking for a conservative investment with steady returns, it’s definitely a good idea to consider investing in index funds.
Index funds offer low commissions, predictable returns, and require little work (or stress).
Contrary to popular belief, they often outperform actively managed funds because of the passive approach. Since the market has a 10% average annual return, index funds mimic the return. A more active approach may have a much higher or much lower return depending on its activity.
What Are The Downsides Of Index Funds?
As with any investment, there are downsides to index funds.
- You don’t get a say in the securities. You invest in a basket of funds and that’s it. You can’t mix and match. You buy the index fund as-is and either keep it or sell it, but you can’t pick it apart and keep only what you like.
- There isn’t an opportunity for huge gains. You won’t beat the market with an index fund. Even though the chances of beating the market investing in individual funds is slim too, there’s a 0% chance with index funds. You limit your returns, but on the flip side, you have a more secure investment.
- You invest in one type of company. When you invest in index funds, you invest in a set group of companies, depending on the chosen index. There isn’t a lot of mixing and matching. While you do get diversification by investing in securities throughout an entire index, there are still limitations.
Can You Lose Money With An Index Fund?
All investments pose a risk of loss.
However the risk of total loss is extremely limited with index funds.
As index funds are so diversified, it’s almost impossible for every single security to fall to nothing at the same time. The entire economy would have collapsed – you’d have more to worry about than your index fund.
Does that mean that the index fund won’t have downtimes?
Nope, they will!
The key is to invest in index funds for the long term. You’ll see the investments go through the ‘bad times’ and hopefully ride out into the good.
What Is An Example Of An Index Fund?
As discussed, index funds mimic an index. Here are a couple of the most popular index funds:
- Vanguard S&P 500 ETF. This is the possibly the most popular index fund. It mimics the S&P 500 and therefore invests in securities of the top 500 companies in the United States. It’s one of the largest and oldest funds on the market and is backed by one of the largest investment firms in the country.
- Fidelity ZERO Large Cap Index Fund. The Fidelity ZERO Large Cap Index Fund also mimics the S&P 500, however, it doesn’t have the S&P 500 name in its title. It therefore skips the licensing fees. This makes the Fidelity index fund less expensive for investors.
- Vanguard Russell 2000 ETF. The Russell 2000 index follows small-cap companies, which is another niche in the market. It consists of 2,113 small-cap companies which include consumer discretionaries, healthcare, and industrial companies. It has a low expense ratio and a high annual rate of return.
ETF vs Index Fund - Whats The Difference?
What Is An ETF?
An ETF is an “exchange-traded fund”.
“Exchange-traded” meaning that they’re traded on stock exchanges such as the New York Stock exchange. Similar to individual stocks.
“Fund” describes the fact that a single ETF is a package of multiple stocks or bonds.
Most ETF’s are actually also Index funds (just to confuse you) in that they’re still designed to match a market index.
However, they differ from an index mutual fund in a couple of ways.
What's The Difference Between An ETF and A Mutual Fund?
One of the biggest differences is that ETFs can be either active or passively managed. Index mutual funds are passively managed.
Let’s explore the other differences between ETFs and Index Mutual Funds.
|ETFs||Index Mutual Funds|
|Lower minimum investment. Purchase 1 ETF “share” for as low as $40.||Most Funds have a minimum initial investment. This may range from $1000-$3000.|
|Buy/Sell||On exchanges, similar to individual stocks.||Buy/sell with the index fund provider directly.|
|Prices||Share price fluctuates throughout the trading day.||Net asset value (NAV) set once daily, at the end of each trading day.|
- Lower minimum investment. Purchase 1 ETF “share” for as low as $40.
- Bought and sold on exchanges, similar to individual stocks.
- Share price fluctuates throughout the trading day.
Index mutual Funds
- Most Funds have a minimum initial investment. This may range from $1000-$3000.
- Buy/sell with the index fund provider directly.
- Net asset value (NAV) set once daily, at the end of each trading day.
What Are The Similarities Between Index Mutual Funds and ETF's?
- Inbuilt Diversification – both contain large numbers of stocks or bonds. As discussed, this reduces risk and the chance of incurring a loss.
- Ability to invest broadly, owning a wide range of companies.
- Both are mainly passively managed. Whilst there is a fund manager to oversee the funds, they’re usually not meddled with once setup.
Index Mutual Funds And ETFs Versus Actively Managed Funds
We’ve already covered some of the differences between active and passive funds but here’s a recap.
As this is the beginners guide to index funds – we won’t go into too much detail.
|Index Mutual Funds and ETF’s||
But the part you’ve been waiting for… which investment makes more money?
Great Alternatives To Investing In Index Funds
Can You Become A Millionaire From Index Funds?
Spoiler alert – yes you can.
In fact it’s become one of the primary tactics used by those seeking financial independence.
How can you achieve this?
- Start now – the sooner you start, the sooner you reap the benefits of compound interest. Time in the market almost always beats timing the market.
- Automate the process – choose a fund and set up your monthly deposit. This guarantees continued account growth and accelerated compounding.
- Be patient and consistent. This is not a get-rich-quick scheme. Good things come to those who wait.
Remember, past market performance is not a guarantee of future market performance.
It’s very likely that some years, your portfolio will have had negative returns.
Looking at the larger picture is therefore super important. Only you can pull the trigger on an investment decision, I’m just offering information to help you make it.
Can You Retire A Millionaire With Index Funds?
When we started writing the beginners guide to index funds – this was the most frequently asked question.
Once again, historically this has been possible.
Our Early Retirement Calculator demonstrates this perfectly.
Take a look at an example:
We’ve used the average S&P 500 returns (10% over the past 90-years), investing $500 a month from aged 25 onwards. As you can see, you would be an index fund millionaire by the age of 58 – despite retiring aged 50 and withdrawing 3.5% of the fund every single year to live on.
If you had invested $1000 instead of $500, you’d be able to retire aged 44, and be an index fund millionaire aged 50.
(The above pictures might be too small to read on mobile, but you can try our early retirement calculator for yourself).
6 Reasons To Consider Investing In Index Funds
We’re approaching the end of our beginners guide to index funds.
But we’ll leave you with some thought-provoking reasons to invest in index funds.
Remember, this is our opinion, for information only. The decision to invest is ultimately yours (or your financial advisors).
1. Index Funds Might Perform Better Than You… Or Your Stock Broker!
As discussed, index funds have historically performed better than actively managed accounts! Funds managed by professional stock brokers are still on average, failing to beat a passive index fund over time.
Why pay a fancy Wall Street investor a bunch of your hard earned profit when you could make more without one anyway!?
2. Index Funds Can Be Less Risky
As we now know, index funds are usually much less risky compared to individual shares.
The biggest advantage when it comes to risk management is that you will avoid losing all of you capital when one investment goes down. Of course, in theory an index fund could lose all its value, but in my unprofessional opinion, that’s highly unlikely.
Certainly much less likely than losing all your money on the next “hot stock tip” from Reddit.
3. Index Funds Can Be Very Cheap!
The goal of investing is to make your money work for you, not for the person handling your money.
Index funds as compared to actively managed funds or individual stocks, usually, have lower costs (particularly when investing through a Stocks and Shares ISA) This can really add up in the long run.
4. Diversification Is Important
As Warren Buffet would say, “Never put all your eggs in one basket.”
Diversify your investment portfolio at all times!
This can be done by extensive research and stock selection – or simply choosing an index fund where it’s done for you.
5. The Past Returns Are Super Solid
Over the past 90-years, index funds have smashed it. Only one in four active managers is able to beat index funds over a long period of time.
Are you willing to risk a portfolio manager with just a 25% chance of beating the index?
Of course, past performance is no guarantee of future performance. But the same lack of guarantee comes with any type of investment…
6. Time Saved Crawling The Stock Market Can Be Spent Making Money!
Researching individual stocks takes time… A lot of time!
Now imagine researching the 200-300 companies in an index fund in-depth.
Then you have to study the charts and learn trend analysis!
An index fund saves you from all of this. Do your due diligence on your one chosen fund… then spend your remaining time making more money!
Concluding Our Beginners Guide To Index Funds
Hopefully our beginners guide to index funds has boosted your investing confidence.
As discussed, investing in index funds is a great way to get your feet wet when investing in the market.
Word of warning – it can be a “gateway” investment.
You may soon find yourself becoming an investment expert (addict).
If nothing else, index funds are affordable, diversified, and convenient. Everything is done for you – all you have to do is invest the money and move onto the next strategy.
Speaking of other investment strategies, check these out: