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how to invest in index funds

"By periodically investing in an index fund, the investor can actually out-perform most investment professionals." 


- Warren Buffett

how to invest in index funds

What's an Index Fund?

An index fund is a fund which mimics an index. 


The S&P 500, the Dow Jones, the NASDAQ, and the Russell 2000 are all examples of US indexes.


Indexes represent a certain segment of the stock market.

how to invest in index funds

S&P 500 Index

 The S&P 500 is made up of the 500 largest companies in the US from a market capitalization point of view. 


Market capitalization = share price * # of shares outstanding


Apple, Microsoft, Amazon, Tesla, Google, and Meta are among the top holdings in the S&P 500 Index.

how to invest in index funds

Dow Jones Industrial Average Index

The Dow Jones is made up of only 30 stocks which represent the 30 large, well-respected companies in the US.


Microsoft, Boeing, Salesforce, Intel, Nike, JP Morgan Chase, Apple, McDonald's, Procter & Gamble, and Coca-Cola are holdings within the Dow Jones Industrial Average.

how to invest in index funds

NASDAQ Composite Index

The NASDAQ Composite Index is made up of over 3500 different stocks.


To be included in the NASDAQ, a company must have earnings of at least $11 million in the previous 3 years and cash flow of at least $27.5 million in the previous 3 years.

INDEX FUNDS... eXPLAINED

The most passive approach to accumulating appreciating assets is long-term investing in index funds.


Index funds come in the form of mutual funds and ETF’s. 


They are a combination of many stocks brought together to mimic specific indexes, such as the S&P 500 or the Russell 2000, meaning they should grow roughly in line with that index. 


Index funds are very popular in that Warren Buffett gave the advice to investors to stick with index funds. 


Index funds are also very popular with the FIRE (Financially Independent Retire Early) movement. 


Holding an index fund in your investment portfolio creates diversity instantly. When you buy a fund that mimics an entire index like the S&P 500, diversity is built in.


Mutual funds include index funds, but not all mutual funds are index funds. Mutual funds can also target specific industries or companies. 


For example, there are mutual funds that only consist of technology companies or energy companies. There are mutual funds that only include growth companies. 


Mutual funds are professionally managed. The downside is that there is a fee associated with many mutual funds because of this professional management, which is identified in the expense ratio.


Make sure you look for low-cost mutual funds with historical good rates of return (usually above 10%). 


If you’ve opened your account with a large discount broker, you can go to their website and search for mutual funds to look at their historic return over the last 5, 10, and 20 years. 


Most brokerages show each mutual fund’s ratings as well as the historical returns and the expense ratios. The lower the expense ratio, the less fees there are associated with the fund. Spend some time comparing the different funds. You’ll learn a lot.


Also, note the turnover ratio.  A higher turnover ratio means the stocks within the fund change more often, generally resulting in higher tax impacts each year.


The other thing to know about mutual funds is when you sell them, you aren’t able to sell them until the end of the trading day. You can put in your sell request at any time while the market is open, but you won’t know the price that you’re selling it at until the close of that trading day. It took me a while to understand this, but it’s generally not that big of a deal, especially if you don’t plan to sell very often.


ETF’s (exchange traded funds) are very similar to mutual funds in that they are baskets of stocks from multiple companies in the same industry or within similar phases of their life cycles. 


The primary difference with ETF’s is that they aren’t managed like the mutual funds. They can be bought and sold at any time while the market is open. In other words, if you want to sell some of your shares at 1pm, then you can sell them at 1pm.  You will get an immediate confirmation instead of having to wait until the end of the trading day. 


ETF’s also generally have lower expense ratios because they are not professionally managed, but not always.


Any of the above choices are great options for consistently investing over time.


If you are planning to retire early and are not sure where to start, contributing to an index fund is your best option. Based on history, the major indexes have grown over time. Yes, there have been some dips along the way, but look at the trends when you do your research. Their overwhelming trajectory is up.

How to Invest in Index Funds

STEP BY STEP: HOW TO INVEST IN INDEX FUNDS

Start Investing Today

1. Open an Investment Account


Research the websites of the large discount brokerages.


Some examples are:


  • Fidelity
  • Charles Schwab
  • Vanguard
  • E-Trade
  • TD Ameritrade


2. Research Index Funds


Index funds come in the form of ETF's (exchange-traded funds) and mutual funds.


Look at your discount brokerage website to confirm these three characteristics of the funds:


     A. Historical returns


This is the most important statistic.  

Find a fund that has performed well over its lifetime and over the last 10 years.


     B. Expense ratio


The expense ratio represents the amount of management costs associated with that fund.  

Find funds with expense ratios less than 0.25%.


     C. Turnover ratio


Turnover represents how many stocks are turned over each year (sold & bought).  

The higher this percentage, the more likely you are to owe tax at the end of the year.  

Find funds lower than 2.00%.


3. Start Investing


Don't fall into the trap of analysis paralysis when you first start investing.


The beauty of index funds is you only need to choose which index you prefer and then choose one of the funds which mimic your chosen index.


To simplify your life and reduce the friction of investing, link your checking account to your investment account.


Choose an amount you will invest every paycheck and transfer the funds every paycheck.


4. Dollar Cost Average (DCA) Your Contributions


Dollar cost averaging is the act of consistently investing, whether that is every two weeks, once a month, or quarterly.


DCA works because the market is volatile.


You may buy 10 shares one week but are able to buy 12 shares the following month due to the prices decreasing.


Setting up a consistent amount to invest and investing in index funds gives you the freedom to not look at your account balance every day.  


You can invest with confidence, knowing your investments will pay off significantly in the long run.

Popular Index Funds

Vanguard 500 Index Fund ETF

Ticker: VOO

0.03% expense ratio


SPDR S&P 500 ETF Trust 

Ticker: SPY

0.09% expense ratio


iShares Core S&P 500 ETF

Ticker: IVV

0.03% expense ratio


Invesco QQQ Trust Series 1

Ticker: QQQ

0.20% expense ratio


Fidelity® NASDAQ Composite Index® Fund

Ticker: FNCMX 

0.30% expense ratio


Fidelity® 500 Index Fund

Ticker: FXAIX 

0.015% expense ratio


Schwab Total Stock Market Index Fund® 

Ticker: SWTSX 

0.03% expense ratio






how to invest in index funds

Summary - How to Invest in Index Funds:

1. Open an investment account.

2. Research index funds (expense ratio, historical returns, turnover ratio).

3. Decide how much you will invest and how often.

4. Start investing.

5. Dollar-cost average contributions over time.

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