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You'll often hear that index funds are the best way for new investors to get started in the stock market. The advantages of putting your money into index funds include:
- Easy-to-make investment decisions
- Performance that closely matches the market
- Relatively low fees
The concept of index investing is simple — purchase shares of index funds and forget about them because you prefer passive to active management of your portfolio. Real-life implementation requires a bit more attention but is still relatively easy. Here's how to get started. (See also: Begin Your Investing Career With Some Mutual Fund Basics)
1. Learn About Stock Indexes
When you hear people refer to an index, they are most likely referencing the S&P 500 (or Standard & Poor's 500), which are 500 stocks considered representative of the U.S. economy. An index fund contains shares of these 500 stocks. Occasionally stocks are dropped and others are added to reflect changes in the economy.
There are many other market indexes, too:
- Wilshire 5000 Total Market, which covers 3,000 to 5,000 U.S. companies on major stock exchanges
- Dow Jones Industrial Average (DJIA), consisting of 30 stocks of large companies
- S&P MidCap 400, representing mid-sized companies
- S&P SmallCap 600, consisting of small-cap companies
- Russell 2000, representing small-cap companies
- MSCI EAFE, consisting of stocks in developed countries of Europe, Australasia, and the Far East
- MSCI Emerging Markets, consisting of stocks in countries with emerging markets
Note that each index and its performance are typically weighted based on market capitalization, which is the company's stock price multiplied by outstanding shares. So, higher valued stocks with more outstanding shares have greater representation or weight in the index than lower valued ones with the same (or fewer) shares.
2. Find and Buy Shares in an Index Fund
Look for a mutual fund screener that allows you to select "index" as a criteria. A great place to find such a tool is your broker's website, which may list index funds separately from actively managed ones. You may find index funds among selections of your employer's 401(k) plan or through a general Internet search of funds matching one of the indexes. (See also: A Guide to Online Brokers for Investing Newbies)
Consider opening more than one brokerage account to broaden your choices. For example, start an account with Vanguard or Schwab to access their selections of low-cost index funds.
There are many types of index funds from which to choose. Look for an all-market index or S&P index fund. For example, the following funds replicate broad market activity:
- SVSPX: State Street Global Advisor S&P 500 Index Institutional Class (minimum investment of $10,000 or $100 for an IRA; annual report expense ratio of .18%)
- PREIX: T. Rowe Price Equity Index 500 (minimum investment of $2,500 or $1,000 for an IRA; expense ratio of .29%)
- FSTMX: Fidelity Spartan Total Market Index (minimum investment of $2,500 or $200 for an IRA; expense ratio of .10%)
- VTSMX: Vanguard Total Stock Market Index Investor Shares (minimum investment of $3,000; expense ratio of .17%)
- SWPPX: Schwab S&P 500 Index (minimum investment of $100; expense ratio of .09%)
Buy shares in an index fund through your online broker, 401(k) plan at work, or directly from the fund company. Just as you would evaluate any other mutual fund, scrutinize management fees along with purchase and redemption fees. Compare performance with its underlying index; the two should be closely related, although fees, trading costs, and other factors may make returns slightly different.
3. Develop a Diversified Portfolio of Index Funds
If you've purchased an index fund based on the S&P 500, then you've covered the domestic (or U.S.) large-cap segment of your portfolio. To create a portfolio using asset allocation principles, buy a few more index funds that represent other portions of the market, such as mid-caps, small-caps, and international stock funds. You might also consider buying bond funds. (See also: Asset Allocation Basics)
To find a mid-cap index fund, look for index funds that replicate the S&P Midcap 400. Similarly, find a small-cap fund based on the Russell 2000 or the S&P SmallCap 600. Your international index funds could follow the MCSI-EAFE and MCSI-Emerging Markets.
Through your search, you'll locate funds like these:
- DISSX: Dreyfus Small Cap Stock Index (minimum investment of $2,500 or $750 for an IRA; expense ratio of .50%)
- NSIDX: Northern Small Cap Index (minimum investment of $2,500 or $500 for an IRA; expense ratio of .15%)
- SWISX: Schwab International Index (minimum investment of $100; expense ratio of .19%)
- VIMSX: Vanguard Mid Cap Index (minimum investment of $3,000; expense ratio of .24%)
- VEIEX: Vanguard Emerging Markets Stock Index Fund (minimum investment of $3,000; expense ratio of .33%)
Target-date, all-in-one, and/or balanced funds have been developed so that you don't have to buy multiple index funds to build a diversified portfolio. However, fees for these types of mutual funds may be higher than traditional index funds.
Index Alternatives
Many index-based mutual funds have ETF equivalents. They may also have enhanced versions, which seek higher returns through certain additions, exclusions, weighting methods, etc. As a result, the fund tends to be less in sync with its index. Plus, management fees are generally higher as these types of funds are actively managed. (See also: ETFs vs. Mutual Funds)
Index investing allows you to match returns of the market: your investment portfolio grows when markets rise, though it suffers when markets are down. Because it's a passive approach, you can spend less time making portfolio adjustments compared to a stock, ETF, or fund picking method. Just be sure to buy low-cost funds that closely match the underlying indexes you have chosen.
Disclosure: This article discusses possible methods of index investing and funds are referenced for general information purposes. Investors should conduct research and/or seek professional advice before investing.
Are you an index fund investor? Which index or indexes do you follow?
