How to Invest in Index Funds: A 10 Step Guide to Success
Investing in Index Funds Complete Guide: Fees, strategy, performance & taxes are just a few of the critical things to consider when investing.
Index funds have become the most popular investment tool in today’s stock market, yet few people understand what index funds are and how they work. All investors need to understand index funds because of their enormous influence. Even if you do not have any money in index funds, they will affect your stock investments because of the incredible size of the index fund industry.
Index fund investing is easy, but there are some complex decisions you will need to make. Understanding these decisions can help you avoid hazards, such as taxes and losses.
How to Invest in Index Funds
1. Understand Index Funds
An index tracking ETF trades like a stock on an exchange and attempts to mimic the movement of a particular stock index such as the S&P500 as closely as possible while keeping fees to an absolute minimum. Low management fees and performance close to that of the underlying index are the hallmarks of an index fund.
The basis of an index fund is an index. An index is a portfolio or list of equities, commodities, or securities, usually stocks. An index fund is an investment fund that only owns equities, securities, or commodities on a specific index. For example, an S&P 500 index fund only invests in stocks on the Standard & Poor’s 500.
The difference between an index fund and a traditional investment fund is that there is no active management. Instead, the fund manager reads the index and buys the stocks on it. When stocks leave the index, the manager sells them.
Today, index funds need no managers, algorithms, or artificial intelligence can read an index and buy and sell stocks. There are now index funds that manage themselves.
A significant advantage to index funds is the low fees they charge. Some index funds charge management fees as low as 0.04%. The costs are low because index funds have no celebrity managers with high salaries and a large staff. Instead, computer programs manage an index fund.
The true advantage of index funds is their simplicity. You need no expert knowledge to invest in an index fund, and the fund enables you to reap nearly the entire profits of the index.
Index funds are popular because of their low cost and the high growth rates some of them can deliver. According to Stock Rover, the Vanguard S&P 500 ETF offered a one-year growth rate of 30%, a five-year growth rate of 16.88%, and a 10-year growth rate of 16.59% to 2021. $10,000 invested in a Vanguard S&P 500 ETF in 2011 could have grown to $46,426 on September 30, 2021.
Many people buy index funds because you do not need to think about them or deal with managers or brokers. Others prefer the high rate of growth in line with the market growth.
Any kind of investment fund can be an index fund. Today there are indexed mutual funds, exchange-traded funds (ETFs), hedge funds, money market accounts, and annuities, to name a few. Investment bankers are experimenting with new index funds, including tokenized funds and synthetic investments built in the blockchain.
The best-known variety of index funds is mutual funds, however. Statista estimates there were 490 indexed mutual funds in the United States in 2020.
Exchange-traded funds, which you can trade through stock exchanges, are gaining in popularity. Statista estimates there were 2,024 ETFs in the United States in 2020, up from 123 in 2001.
2. Consider the 5 Pros of Index Funds
There are 5 major benefits to investing in index funds.
Diversification
Steady High Returns
Little Work or Research is Necessary
Index Funds Beat Inflation
Investing in Index Funds is Easy
Diversification
Indexing is a risk management tool that reduces risks through diversification. Diversification means buying many investments to reduce risks.
The theory behind diversification is that you can lose all your money if you concentrate your investment in one sector. A tech sector crash could wipe out a person who owns only technology stocks, for example.
Diversification tries to protect a nest egg by putting money into different sectors or investments. The theory is that you are less likely to lose your money if you diversify your investments. Experts recommend diversification for people saving for retirement.
Advocates believe the more diversification, the higher the margin of safety. Indexing is an effort to achieve a high level of diversification. An S&P 500 Index Fund includes 500 stocks in many industries and is one of the most diversified investments available.
People who purchase index funds are buying a diversification strategy. They design funds such as the SPDR S&P 500 ETF Trust (NYSEARCA: SPY) to offer a high margin of safety. The hope is that SPY will retain value because it holds equity in the 500 most successful companies in the USA.
They base the diversification of Index Funds on Modern Portfolio Theory. Economist Harry Markowitz created Modern Portfolio Theory in the 1952 Journal of Finance paper Portfolio Selection. The theory was so influential, Markowitz won a Nobel Prize in Economics for it.
Modern Portfolio Theory teaches that the right mix of investments can offer higher returns and lower risks. When fund managers create an index, they are trying to apply Modern Portfolio Theory.
Steady Returns
Index funds are popular because many of them offer high rates of return on a steady basis. The S&P 500 offered an 18.4% annual rate of return in 2020, and a 31.49% annual rate of return in 2019, according to Stock Rover. The S&P 500 offered an average long-term return of 9.64% in the period ending on February 1, 2021.
One belief behind indexed funds is that the regular high rate of return will cancel out losses. The S&P 500’s 31.49% return in 2019 and 21.83% return in 2017 made up for the -4.38% loss in 2018, for example.
Many investors believe the high returns and steady growth reduce risk. The constant growth offsets losses in declining industries and reduces the risks from economic downturns and market losses.
One risk indexing reduces is technological progress. Constant technological change destroys companies and industries by making products and services obsolete. Owning an S&P 500 Index fund ensures that investors own stock in companies that offer new technologies. An index investor does not have to worry about the death of traditional television because Disney (DIS) is part of the S&P 500.
An S&P 500 index fund, such as the SPY or the Vanguard S&P 500, will hold stock in technology companies such as Apple (AAPL) and rising businesses like Tesla (TSLA). The S&P 500 investor theoretically enjoys the benefits of technology stocks without the risks.
Little Work or Research is Necessary
One reason for the popularity of index funds is that investing in them often requires little work or research. Index fund investors do not have to spend hours researching individual stocks or companies. No knowledge of the markets, the economy, technology, products, or politics is necessary. All the investors need to do is put money in the fund.
When you own an S&P Index Fund, you do not have to follow the market daily or individual stocks. The fund will buy stocks based on their market caps.
Index funds are popular with investors who do not have time for research. Professionals with full-time jobs and families like index funds because they make investing fast and simple.
Many advisors recommend index funds because they require little investor education. The advisor does not need to spend hours explaining an investment or the markets to a person who dislikes talking about financial matters. Index funds are popular because they require little thought, work, time, or research.
Index Funds Beat Inflation
Many people buy investment funds because they beat inflation in an age of low savings account returns.
The US annual inflation typically oscillates between 2% and 3%, while the S&P 500 offers a long-term annual return of 7% and 9%, which means an inflation-adjusted return of 6%.
The average interest rate for a US savings account is 0.06%, and Index Funds also beat government debt as the daily yield curve on a 30-year US Treasury Bond is 2.04%. The daily yield curve on a 20-year Treasury bond was 1.99%, and the return on a 10-year treasury bond was 1.48%.
Indexed funds are one of the few investments that beat inflation that investors can easily access.
Investing in Index Funds is Easy
Index funds are popular because they are simple and easy to invest in. You can buy fractional shares of index exchange-traded funds (ETFs) through apps such as Robinhood, the Cash App, Interactive Brokers, Gemini, and WeBull for as little as 1¢.
A fractional share is a tiny percentage of a stock or ETF. For example, you could buy $5 worth of the SPDR S&P 500 ETF Trust (NYSEARCA: SPY). People who cannot afford to pay several hundred dollars for a SPY share can invest in SPY with fractional shares.
Anybody with the money can purchase index mutual funds from companies such as Vanguard and Fidelity. You can begin the purchase process by going to the company’s websites.
Many organizations allow employees to purchase mutual funds and ETFs through 401k and other investment plans. The advantage of these tax-deferred investments is that they take the funds from your salary. Many organizations’ human resources departments make it easy to enroll in 401k plans.
3. Understand the 4 Cons of Index Funds
Index funds have drawbacks that make them poor investments for some. The investment media, financial advisors, and fund companies often hide these drawbacks to make index funds more appealing. All investors need to understand index funds’ limitations.
Individual stocks can grow faster than indexes.
According to Stock Rover, the 5-year return of Amazon.com is 325% versus the S&P 500 return of 112%. Individual stocks could better serve people who want high growth rates and investments they can sell for cash. Individual stocks can offer higher rates of growth and return. Stocks are also better for speculation. The tough challenge is picking the right stocks that will beat the market in the future.
The risks from individual stocks are far greater than the risks from index funds. Diversification reduces risk, but it often leads to lower overall returns.
Everybody who buys an index fund must realize that they are forgoing other opportunities that could be far more profitable but that those opportunities will carry far higher levels of risk.
There is no guarantee of index growth and returns.
The great attraction of indexes is the long-term margin of safety and steady growth that indexes offer. Index funds can suffer enormous short-term losses, however.
The S&P 500 lost 38.49% of its value during the financial crisis crash of 2008, but in 2009 it recovered from that loss when it grew by 23.45%.
The S&P 500 can suffer multi-year losses during a stock market crash. According to Stock Rover, the S&P 500 shrank in 2000, 2001, and 2002 and fell by 10.14% in 2000, 12.04% in 2001, and 23.37% in 2001.
History shows that steady index growth is not guaranteed. There have been periods of losses. Index recovery can come fast; Stock Rover estimates the S&P 500 grew by 26.38% in 2003.
Investors need a system to help them avoid stock market crashes when investing in index funds.
Index investors have no control over the fund holdings
Many people love index funds because they do not have to research or pick stocks. This lack of control can create moral and other hazards for investors.
An index fund could hold stocks in companies in which investors have moral or philosophical objections. An S&P 500 fund could own tobacco companies, gambling companies, distillers, brewers, companies that distribute offensive entertainment programs, oil companies, defense contractors, and companies that build weapons. An index could also hold stock in companies that engage in union-busting and outsourcing or companies that donate money to politicians people object to. Many large American companies donate to individual politicians and organizations, such as the Republican and Democratic parties.
A new type of index fund is emerging based on Environmental, Social, and Governance (ESG). ESG indexes refuse to invest in oil companies, for example. There are also indexes based on Christian and other religious values. They design some indexes to fit moral criteria.
The proposed Alpha Architect ETF Trust will only hold stock in companies run by what its creators call “high-character” CEOs, a Securities & Exchange Commission (SEC) filing claims. The high character could mean CEOs with high ethical standards or exemplary behavior.
You will be stuck with the index’s strategy
Managers design index funds to implement a strategy automatically, an S&P 500 Fund will sell any stock that leaves the Standard & Poor’s 500, no matter how good that stock is.
Research Affiliates analysts allege Apartment Investment and Management (AIV) outperformed Tesla (TSLA) in July 2021, Yahoo! News reports. Tesla Motors replaced Apartment Investment and Management on the S&P 500 in December 2020.
Most S&P 500 fund owners invest in risky stocks they would normally avoid because those stocks are in the index. They base the S&P 500 Index only on the market capitalization of companies. Nobody evaluates S&P 500 stocks for their performance.
Index fund investors need to be comfortable with the index’s strategy because they are stuck with that strategy.
4. Choose a Taxation Method
How the government taxes a fund can determine how much money you can make from it. Choosing the wrong taxation method can lead to a high tax bill and conflicts with the IRS. Current tax law gives you three options for index fund investing: Traditional IRAs, Roth IRAs, and taxed investments.
Traditional IRAs
A traditional individual retirement account (IRA) is tax-deferred. That means you do not pay taxes until you take money out of the account. The advantage to a traditional IRA is that the IRS will not tax funds in it, so a traditional IRA can reduce your taxable income.
The disadvantage of a traditional IRA is that money is taxable when you withdraw it. Traditional IRAs can be a poor deal for younger and lower-income persons because early withdrawals could increase your income tax bill.
Traditional IRAs can also have tax implications for retirees. The Internal Revenue Service (IRS) taxes traditional IRA withdrawals at the owner’s current tax rate after retirement.
Drawbacks to traditional IRAs include strict contribution limits ($6,000 for people under 50 and $7,000 for people over 50 in 2021). The IRA contribution limit can change, so you will need to check them. The IRS can penalize you for contributing too much money to an IRA.
Current law requires minimum distributions (payouts) from traditional IRAs after age 72. An IRA could increase a person’s taxable income by making payments they do not need.
Traditional IRAs are popular because they are easy to set up. Many people get traditional IRAs through their employers.
Roth IRAs
Roth IRAs offer more tax advantages than traditional IRAs at a price. Holders pay no taxes on money they withdraw from a Roth IRA.
Roth IRA holders, instead, make nondeductible contributions. The Roth IRA holder pays the taxes now to avoid future taxes. A Roth IRA can increase your tax bill.
A Roth IRA can be a good deal for a person who makes a high income while working and can afford taxes. The holder can avoid paying taxes when she is retiring and living on a limited income.
Roth IRAs are confusing because they resemble traditional IRAs. There are $6,000 a year Roth IRA contribution limits for people under 50 and $7,000 a year Roth IRA contribution limits for people over 50.
High-income individuals cannot contribute to Roth IRAs. The IRS banned singles making over $161,000 a year and married couples making over $208,000 a year from contributing to Roth IRAs in 2021.
They named Roth IRAs for US Senator William Roth Jr. (R-Delaware), one of the sponsors of the Taxpayer Relief Act of 1997. That act created Roth IRAs.
Taxable Index Fund Accounts
Many people find buying index funds through a taxable account easier and cheaper than IRA investing. Paying taxes is often cheaper than paying the tax penalties associated with IRAs.
Younger people and individuals who think they will need to take money out early need to avoid IRAs. A person under 50 could lose money from an IRA if he has to withdraw money because of emergencies.
Many people pay high taxes because circumstances, such as job loss, force them to make IRA withdrawals. Buying index funds outside an IRA can be a better tax strategy for persons with unstable incomes, such as the self-employed.
One advantage to taxable accounts is that a person can invest over $6,000 per year in them. You can invest unlimited amounts of money in taxable index accounts.
A second advantage is that you can sell taxable index funds for extra cash. Parking extra cash and savings in an index fund can be a smart strategy because index fund return on investment (ROI) exceeds inflation.
A final advantage to taxable accounts is that you can purchase small index funds to augment your savings. Taxable index funds are a good savings strategy because of higher returns.
5. Select Your Strategy
There are three popular index fund investment strategies in use today; Portfolio diversification, concentration, and duration of the investment.
Diversification
Diversification is the best strategy for people who cannot afford to lose money. Diversified portfolios retain value by holding many stocks and limiting exposure to specific industries or sectors. A downturn in tech, retail, banking, or manufacturing will not limit an S&P 500 Index’s value because it holds stocks in all those sectors. Diversification can limit returns because different sectors grow at different rates.
Concentration
Concentration can increase returns by buying stocks in one sector. A FAANG; Facebook (FB), Apple (AAPL), Amazon (AMZN), Netflix (NFLX), and Google (GOOGL) index concentrates on tech, for instance. Concentration leads to higher returns and higher risks.
Duration
Duration is the time that a person plans to hold an investment. The duration should determine the strategy. If you plan to hold stocks for a short duration, a concentration strategy makes sense. Concentration is best for short-term holders because it can deliver a higher rate of return. Diversification is best for long-term investors because it limits risks. A long-term investor can afford the lower return on investment from a diversified portfolio. A short-term investor cannot afford the lower ROI from a diversified portfolio.
Asset Location
Asset location is a tax-reduction strategy that uses the different tax treatments the IRS gives to various tax kinds of investments. In asset location, an investor determines which investments offer the greatest tax benefits and puts a specific amount of money into them.
The simplest location strategy has both taxable and tax-deferred accounts. The investor determines how much money to hold in a taxable index fund and keep in a tax-deferred account.
People who could need access to their money should put most of their money in a taxable account. Individuals who can live without the money will benefit from tax-deferred accounts such as IRAs and Roth IRAs.
6. Consider Your Ethical Investing Strategy
Whether you want to invest ethically or not is your choice, but understanding your options is important.
ESG Investing
ESG is a set of standards for ethical investing. Environmental means companies that do not pollute or contribute to global warming. Many people refuse to hold oil stocks to protect the environment.
What is ESG investing? Investing in Companies with a Good Track Record on Environment, Social & Governance