How to invest in index funds: Do it right

What is an index fund?

Index funds are baskets of stocks that follow a specific market index. For example, popular index funds give you exposure to the same stocks as the S&P 500, Dow Jones Industrial Average, Russell 2000, and other indices. Each index tracks the performance of a specific group of investments, usually stocks, with a related theme or topic.

If you look at the history of index funds compared to actively managed funds, index funds tend to win about 80% of the time. It's also important to remember that the current situation is temporary. Historically, you are likely to get a better annual return if you invest in the stock market, then if you just let your money sit in the bank account, thanks to compound interest. Just remember to invest in the long-term and only invest money that you won't need for at least five years or longer.

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History of index funds

Index funds were the brainchild of University of Chicago graduate students Paul Feldstein and Edward Renshaw, who in 1960 proposed the idea of an "unmanaged investment company."

They said investment advisers rarely got better returns for their clients than the major stock averages, so investors might as well have a portfolio that automatically buys every stock in the Dow industrials or some other index.

It took more than 10 years before the Qualidex Fund was launched, giving pensions a collection of Dow stocks. Then, in 1976, Vanguard Group offered an S&P 500 fund that's regarded as the first index fund for individual investors.

Should you invest in index funds?

It's estimated that index funds currently hold about one-fifth of all the money currently invested in the U.S. stock market.

Why? Mainly the reason Feldstein and Renshaw noticed almost 60 years ago: Index funds often do better than fancy portfolios managed by professional stock-pickers.

Legendary investor Warren Buffett made a bet in early 2008 that an S&P 500 index fund would beat a basket of actively managed hedge funds over 10 years.

By the end of 2017, it was clear Buffett had won the bet. Today, his net worth proves his stock market savvy.

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How to invest in index funds: step-by-step guide

Now that you understand index funds, here's the three-step process you can follow to invest in index funds and grow your portfolio.

Step #1: Pick a brokerage and open an account

To buy an index fund, you need a brokerage account. Once your account is funded, you can buy and sell index funds like exchange-traded funds (ETFs) or mutual funds. Both give you access to the same underlying stocks and other assets. However, the way you buy and sell them works a little differently.

In the fall of 2019, most of the large discount brokerage firms dropped fees for trading ETFs. Some charge up to around $50 per trade for mutual funds, however. Here's a glance at where you may want to start.

Fidelity and Vanguard are arguably the best brokerages for mutual fund index funds. Each of these brokerages has its own family of mutual funds that you can trade with no fees. They may also offer a larger list of partner funds you can buy with no-load and no-transaction-fee. Do your best to avoid big fees for buying and selling funds.

For ETFs, you have a wider array of choices with no trade fee. In addition to Fidelity, take a look at Ally Invest, Public, and E*TRADE. All offer no-fee trades for stocks and ETFs:

Also, you can check out our best brokerage list for an updated view of where to keep your cash and index funds.

Step #2: Pick your first index fund

If you're ready to get started, you need to pick your first index. While you may be tempted to buy one of the really big, popular S&P 500 funds they talk about in the news, it's a good idea to do your own research and choose the fund and index that make the most sense for you.

Investing in the S&P 500 is a popular starting place for good reason, however. This group of 500 of the largest stocks in the U.S. has provided a historical average return of around 10% per year over a long period. While there is undoubtedly volatility and past performance isn't a guarantee of the future, this is considered one of the safer, cheaper ways to invest.

S&P funds from places like Vanguard, iShares and Fidelity charge you less than 0.10% in annual fees. Thanks to cutthroat competition, a few have dropped below 0.05%. But bad ones can charge more than 2%, so look at that expense ratio before buying.

But that's just a starting point. There are many, many indices to choose from for future investments:

• Some are broad market like the S&P 500.
• Others focus on specific industries, company sizes, commodities, countries, regions, asset classes, and other criteria.

For more research, check out ETF and mutual fund screeners that allow you to sort through giant lists of funds quickly using criteria including expense ratios and other factors.

Step #3: Enter your trade

ETFs are similar to stock trading. You can buy shares of any ETF during market hours, often with no transaction fee, and have your order execute immediately. Mutual funds allow you to buy whole-dollar amounts and have all trades execute at the end of the market day.

There are pros and cons to each.

• For most people starting out, ETFs are easier.
• Mutual funds are excellent for long-term investing.
• Both ETFs and mutual funds have an annual fee, called an expense ratio.
• Sometimes ETF fees are lower, and sometimes mutual fund fees are lower. So take a look at a few options for each index before buying in.

Why you should keep most of your portfolio in index funds

If you still want to try your hand at going the active management route – either with funds or by managing your own portfolio – an excellent strategy would be to put the majority of your portfolio into index funds, and actively manage the rest. Here's why:

Most fund managers don’t beat the S&P 500

According to the S&P Indices Versus Active, or SPIVA, 60 to 80% of actively managed mutual funds and ETF’s underperformed market indices in various categories for year-end 2012. What’s more, the rate of under-performance increases the longer the comparison is made.

An actively managed fund might outperform the market for a year or two, but the evidence weighs heavily against them over periods of five years or more. Many investors will go with actively managed funds based simply on the fact that they outperform the market for a single year. After all, those will be the funds that the financial media will hold up like the stars in their year-end fund rankings.

Actively managed funds and individual stocks require more action from you

Not only do most actively managed funds underperform the market, but they generally require greater time and attention on your part. If you are investing in index funds, you know the returns will match market performance. But if you are investing heavily in actively managed funds, you will constantly have to monitor those funds to see where you stand.

There can be an even bigger dilemma than it seems at first glance. If you are in a particular managed fund and outperforming the market, you may become complacent, thinking that it will always be this way. But then you can get burned in a big way when that situation reverses.

On the flip side, if you see your fund constantly trailing the market, you might sell at a particularly bad time. Underperformance can lead to panic selling.

Either way, you always have to keep an eye on your fund investments, in much the same way that you would do if you hold individual stocks. That largely defeats the purpose of having funds at all.

And speaking of individual stocks, they are at the opposite end of the investment spectrum. If index funds represent passive investing in equities, managing a portfolio of individual stocks is something like a part-time babysitting job – only the stakes are much higher. Read our stock trading beginner's guide with individual stocks investing tips.

“Small” investment fees diminish your returns in a big way

Another major issue in the active-vs.-index funds debate are investment fees. Since index funds track entire markets, their portfolio composition changes only when there are changes made to the index. Since that is fairly infrequent, index funds incur very little in the way of investment fees.

Actively managed funds on the other hand, can adjust portfolio holdings far more frequently, and as they do they incur higher investment fees. How high these fees will be will depend upon the turnover ratio within the fund. But on those that are on the higher end of the scale – where portfolio turnover exceeds 100% per year – investment fees can be quite high.

If the annual average investment fees on an actively managed fund is 1% higher than they are for an index fund, your return on that fund will be lower by 1% each year.

Considering the stock market averages roughly 8% per year over the very long-term, $100,000 invested in an index fund, returning 8%, will produce a portfolio size of $466,000 in 20 years.

Assuming that an actively managed fund will get the same 8% return – but remembering that most don’t – then subtracting out 1% from their return for higher investment fees, your average annual return will be 7%. This will produce a portfolio size of $387,000 in 20 years.

That “small difference” in investment fees becomes big money over long periods of time. In this case, it will cost you $79,000 over 20 years.

It goes without saying that if you manage your own stock portfolio, your investment expenses will be even higher than they will be for actively managed funds. That will make a negative effect on your portfolio even higher over the decades.

Can you buy index funds with a robo-advisor?

Robo advisors are online investing platforms that use algorithms and mathematical rules to create and manage investment portfolios.

When a robo advisor builds a portfolio, it takes into account the investor's goals, risk tolerance, and time horizon. The robo advisor then determines the ideal asset allocation for your needs and makes sure it maintains that ideal balance.

Most robo advisors use index funds to achieve their goals. However, robo advisors may not be the best way for you to purchase index funds:

1. You won't get much say in which index funds the robo advisor purchases. Robo-investing platforms are designed to be indeed “set it and forget it.” Although the robo advisor may allow you to pick which sectors you want your money invested in, you won't have as much control over your funds as if you used a stock broker.
2. Most robo advisors charge annual fees. Since many brokers have eliminated commissions on trades, you'll save money by using a broker rather than a robo advisor.

Two of the leading robo-advisors are Wealthfront and Betterment and both. They both charge an annual fee of 0.25% and offer a great costumer service.

The bottom line on Index fund investing

If your portfolio is exciting, it may be too risky. Index funds have their own risks and should not make up 100% of everyone's portfolios. But they are popular for very good reasons. Adding a regular, consistent amount to your investments is called dollar-cost averaging. This is a solid strategy for building up an index portfolio from zero over time, even during a market downturn.

And if you can achieve market-level returns at rock bottom costs with instant portfolio diversification, why would you invest any other way?

Index funds are just one way you can diversify your investments, which is one of the surest ways to weather stock market volatility. For most, index funds should be a major part of your investment strategy.

More: Types of mutual funds to invest in