Why Investing in Index Funds is Perfect for First-Time Investors

If you think you need to earn a certain amount of money or hit a particular age to start investing, think again. There are plenty of options for new investors, including index funds. 

Index investing was created by Jack Bogle, founder of Vanguard, in 1975 and has become the most popular passive income strategy when it comes to investing in the stock market. Wall Street history aside, it’s important to know this: index funds are actually pretty easy and don't require a lot of money to get started. They're designed to replace a human at the helm while attempting to beat the market and keep your costs as an investor to a minimum.  

What are index funds?

An index fund is essentially a mutual fund or exchange traded fund (ETF) that tracks the performance of a particular index and takes the guesswork out of selecting individual stocks for your portfolio. When you invest in index funds, it's a way to passively invest in all of the companies that are in that index. That way, your portfolio has built-in diversification, with relatively low expenses.

How are index funds different from mutual funds?

Like mutual funds, index funds give investors the opportunity to buy a chunk of the market in one transaction. But because index funds take a passive approach to investing by tracking a market index rather than using a professional to take an active approach to building and managing the investment, index funds tend to carry lower fees than mutual funds. 

Are index funds safe?

Investing always carries risks. There is no surefire way to guard your funds against investment losses with index funds. The stock market is volatile year to year (with wild fluctuations day to day). However, if we zoom out by 10 years, the stock market has increased in value. That’s why it's best to take a long-term investing approach with index funds in order to allow your investments to grow over time. Buy when the market is low or during recessionary times to maximize your profit once the market returns to its healthier seasons.

What's the difference between index funds and stocks?

Stocks are publicly traded shares of a company that provides you with ownership in one particular company, such as Amazon, Apple, or Target. Investing in one company exposes your funds to increased risk, should the company’s stock take a tumble or become insolvent. As a beginning investor, a good rule is to limit individual stocks to about 10 percent of your overall portfolio. Be sure to do your research, proceed with caution, and choose your individual stocks wisely. 

If investing in a single company is not your thing or you don’t want to put the energy into researching the company, then investing in an index fund may be the next best thing. Index funds are a collection of stocks that allow you to diversify across industries, company sizes, and geographic regions, just to name a few. Index funds also have low expenses, since there isn’t anyone behind the curtain buying and selling shares of companies without you knowing about it. It’s all done automatically.

What about index funds and ETFs? How are they different?

Index funds and ETFs can look almost the same on the surface—they both allow for passive investing, mirror an index, and are low-cost forms of investing. But they’re more like sisters when it comes to an index investing strategy. Index funds have been around since 1975, where ETFs hit the stock market scene in the 1990s. This has given index funds a slight edge when it comes to funds under management, but ETFs are the second most popular passive investment vehicle and continue to gain ground. Here’s how they are different.

1. Liquidity: The biggest difference between ETFs and index funds is that ETFs can be traded throughout the day on the stock exchange like stocks. This can be attractive for active investors who like to chase price movements during the day. However, for new investors, this can be an attractive feature if they want to cash out on an uptrend or stop their losses if the ETF begins to take a dip. This may not be a concern if you are investing for the long term and simply have your funds invested for the ride. Index funds can only be bought and sold for the price set by the market at the end of the trading day.
2. Minimum Investment: With ETFs, you can buy one share or a fractional share to invest in the fund, making the barrier to entry much lower than an index fund. Many index funds come with a minimum investment amount by the broker that are higher than the price of one share of an ETF. However, there are index funds that come with no minimum investment requirements to join the fund.
3. Dividends: Index funds automatically reinvest dividends, which maximizes the growth of your investment through compounding. ETFs stockpile the dividends until the end of the quarter and then distribute them as cash to investors or as additional shares in the ETF. This distribution becomes a taxable event to the investor.
4. Fees: Both ETFs and index funds are low costs options to investing, with many ETFs coming in at a hair less than index funds. But ETFs can come with additional fees such as trading commissions—if your online broker charges for trades—and costs associated with the bid-ask spread.  Although these fees are relatively small, they can add up over time if you buy and sell frequently, eating away at your returns.
5. Taxes: ETFs are more tax-efficient than index funds because if you decide to sell your shares, you will be responsible for the capital gains tax. With an index fund, any withdrawal request from another investor in the fund triggers a sale of shares and the capital gains tax is spread across all the investors in the fund. You can pay taxes, even if you don’t sell any of your shares.

How do you invest in index funds?

To purchase shares of an index fund, you will need to open an investment account with a discount broker, such as Fidelity or Merrill Edge. Index funds can be purchased in a brokerage account or an IRA account. Once funds are transferred and available, you can select to purchase the index fund with a fixed dollar amount or by the number of shares you would like, depending on your budget. For example, if you have $1,000 available and each share of an index fund is $100, you can purchase any amount up to $1,000 or you can purchase anywhere between one and 10 shares of the index fund.

Investing in index funds can be easy if you’re a beginning investor or if you want to keep your investing strategy fairly simple. If you’re looking to invest and forget over the long term, then index funds should be taken into consideration as a part of your overall investment plan.