Index fund investing is one of the most popular forms of investing these days, and with good reason. It’s an easy to set up, low cost, and effective investment strategy for beginners and experts alike. Learning how to invest in index funds is simple too, especially when you have the right guidance on how to get started.
Luckily, all the guidance you need can be summarized in 5 simple steps, which we’ll walk through below.
How to Invest in Index Funds in 5 Easy Steps:
- Decide on the Right Investment Account
- Select an Online Broker
- Determine your Initial Deposit
- Choose your Blend of Investment Vehicles
- Set an Ongoing Strategy and Maintenance Plan
Disclaimer: Just Start Investing is not a certified financial advisor. This post lays out the steps to get started and the investing principles that we practice.
What is an Index Fund?
An index fund is the combination of an index and a mutual fund.
A mutual fund pools money from multiple investors in order to purchase a larger, diversified group of assets. Mutual funds are typically managed by a person (fund manager), and investors are charged a fee for the convenience of this diversification (and to cover the cost of having the fund manager).
An index fund combines the two concepts. Essentially, it’s a new and improved mutual fund that matches a broad index instead of hiring an expensive manager to pick stocks. This, of course, keeps expenses low and more money in the investor’s pocket.
Note: sometimes an index fund is called an index mutual fund. These are usually the same thing and should still have a low average expense ratio.
Step 1: Decide on the Right Investment Account
In general, when starting to invest in index funds, it is commonly advised to first max out tax-advantaged accounts (like Roth IRAs) and then deposit additional funds into a personal brokerage account.
Listed below are the three most common types of investment accounts. You can get all the details on investment accounts here if you need further information to help you decide where to start.
1. Personal Brokerage Account: A basic and flexible account with few limitations (but also no major tax benefits).
- No major tax benefits
- No limits to contributions
2. Traditional IRA (or 401k): Retirement accounts that provide tax benefits when contributing funds into the account.
- Can contribute money pre-tax
- Limited annual contributions ($19,500 for 401(k)s, $6,000 for IRAs)
3. Roth IRA: A retirement account that provides tax benefits when withdrawing earnings.
- Can withdraw earnings without taxes (after age 59.5)
- Limited annual contributions ($6,000 for IRAs)
This is not an exhaustive list, but these are the top choices for beginners and all you need to know to get started.
How JSI Invests: First, we max out employer contributions in a 401(k). Second, we max out contributions to a Roth IRA. Third, we go back to our 401(k) to add more contributions, and then deposit additional funds into a Personal Brokerage Account.
Here is a guide on the best order to invest, in case you want to learn more:
Step 2: Select an Online Broker
Traditional Online Brokers
Traditional brokers give you more control over your investments. You select exactly which vehicles to invest in (while keeping costs very low if you go with a reputable broker like Vanguard or Schwab).
- Low fees (expense ratios and trading costs)
- 100% control over your investments
- Requires slightly more oversight and attention
- Manual tax optimization required
Charles Schwab is one of the best online brokers out there. It offers a wide variety of low-cost index funds and ETFs, and in 2019 dropped their trade commission fee to better compete with some new fin-tech companies (like Robinhood).
Their platform is relatively easy-to-use, which makes Schwab a great spot to set up a sound index investing strategy.
Overview of Schwab fees:
- 0.02% lowest fee (expense ratio) for an ETF or index fund
- $0 commission per trade
While Vanguard doesn’t have the absolute lowest fees or sleekest online platform, it does have a long history of being a trusted broker for index investors. Plus, their funds offer fees that are still very low.
Overview of Vanguard fees:
- 0.04% lowest fee (expense ratio) for an ETF or index fund
- $0 commission per trade (with Vanguard funds)
Robo-advisors are online platforms that do 99% of the work for you. In most cases, you complete a set of questions before opening an account and the advisor will automatically select investment vehicles for you based on your answers.
- Easy to set up
- Automatically manages and rebalances portfolio ongoing
- Tax-loss harvesting capabilities (which is complicated and can sometimes save you money)
- Slightly more expensive
- Lack of customizability
Robo-advisors in general win out on ease of use. Especially with Betterment, who offers a clean and easy to navigate interface. Plus, once you answer their questions upfront, Betterment manages your investments for you. It doesn’t get much easier than that!
However, Betterment does come with a cost premium – a 0.25% management fee. This is a significant added cost to your investments, so you need to be sure that the simplicity that Betterment brings to your life is worth the extra cost!
- 0.25% management fee
- 0.03%-0.25% range of fees for ETFs
Blooom is a unique robo-advisor because it focuses mainly on 401(k)s. It doesn’t offer a variety of investment funds, but instead connects to your existing 401(k) provider to offer optimization tips, potentially even managing your account for you.
Blooom offers two levels of service:
- A Free 401(k) Health Check-Up: Blooom can hook up to your 401(k) to review your account and provide recommendations on how to optimize your investments
- Paid Ongoing 401(k) Management: Blooom offers ongoing 401(k) management, so an investor can take a more passive approach and let them take the wheel
- Free 401(k) analysis
- $10/month flat fee for ongoing 401(k) management
How JSI Invests: Follow this step by step guide to open an account and start investing with Schwab today (JSI uses Schwab to invest). You can use Schwab to open IRAs, personal brokerage accounts, and other types of accounts as needed.
Step 3: Determine your Initial Deposit
Before determining your initial deposit, it’s best to first understand your goals and set a savings and investing plan to reach them. Anything you invest now should not be money that you need in the immediate future.
As stated in step 2, it is usually smart to first max out tax-advantaged accounts (like a Roth IRA and 401k), and then contribute leftover savings to a personal brokerage account.
At the end of the day, only you can decide the right amount of money to deposit into investing accounts based on your specific income and monthly expenses. Don’t stress too long over this decision, your initial deposit is actually less important than the ongoing deposits you’ll make over time (detailed in step 5).
Pro Tip: make sure you invest enough in your initial deposit to cover any minimum investment rules within your broker or fund.
How JSI Invests: In order, first we contribute 5-10% (or more) to a 401k. Then, we put the annual $6,000 into a Roth IRA. Last, any additional funds go into a personal brokerage account. We’ve found that building a custom budget that maximizes saving ability works well.
Step 4: Choose your Blend of Investment Vehicles
There are a few asset classes and investment vehicles to choose from when starting to invest in index funds.
Asset classes are broad categories and types of investments, like stocks and bonds. Investment vehicles are specific investments that you buy and sell. Below is an overview of both:
Asset Classes: Types of Investments
- Equities / Stocks – pieces of individual companies
- Bonds – a loan that you issue to a company, government, etc.
- Real Estate – physical property
- Cash – money on hand or in a bank account
Investment Vehicles: Where You Invest Your Money
- Individual Stocks – buying pieces of individual companies in the stock market, like Apple (AAPL) and Walmart (WMT).
- Mutual Funds – A group of assets (typically stocks, but can be bonds and other vehicles) that you can purchase by pooling money with other investors (i.e. VTSAX, a dividend mutual fund). Provide easy diversification, but are usually actively managed, which leads to higher costs.
- ETFs & Index Funds – A group of assets (typically stocks, but can be bonds and other vehicles) that you can purchase by pooling money with other investors (i.e. SCHX, a large-cap ETF). Allows for easy diversification, and mirrors a market index (like the S&P 500 index or total stock market index) without active management.
- Bonds – Bonds can be invested in individually or through ETFs and various bond index funds. They offer a lower return (typically 2-3% annually) and are viewed as safer investments than a stock.
How JSI Invests: In low-cost bond and equity index funds or ETFs (like an S&P 500 index fund). We try to keep it simple, which the two resources below can help with. Remember, the best index funds tend to have low expense ratios.
Simple Investment Strategies:
- Creating your own lazy portfolio is a great option for this step.
- Building a 3 Fund Portfolio will really keep things simple and is one of the best index fund strategies for beginners.
Step 5: Set an Ongoing Strategy and Maintenance Plan
Setting an ongoing strategy and maintenance plan is important for all investors. While you don’t need to check on your investments daily (and you probably shouldn’t), you should still be depositing funds monthly and rebalancing your portfolio annually.
- Annually: Rebalance the portfolio to ensure the weight of equities vs fixed income is in line with set goals, as needed.
- Monthly: Deposit money based on an ongoing savings plan that fits your monthly income and expenses.
How JSI Invests: We deposit money monthly and use that opportunity to rebalance our portfolio as needed.
Want even more guidance on how to invest in index funds? View the resources below to start today:
- Get started with Charles Schwab: Step by step guide to start investing with Charles Schwab
- Get Started with Betterment: The 3 step plan to get set up with Betterment
The Benefits of Index Investing
As mentioned at the beginning of this article, index investing is a great strategy for both beginners and experts. There are four major pros when it comes to investing in index funds.
It’s Easy: As we walked through, starting to invest in index funds is easy. You can become an index fund investor today in just 5 simple steps.
The Expenses or Low: Top index funds are extremely low cost, especially compared to an actively managed fund (usually an actively managed mutual fund) where they have lower expense ratios.
You Get Instant Diversification: Many index funds provide broad diversification with just one purchase.
It’s a Proven Strategy: The S&P 500 is a particular index that has a proven track record of historical success (in the past, the S&P 500 index has had an average return of around +7% annually).
Every day you wait is less money in your future pocket, so get started today!