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A Beginner's Guide to Investing in Index Funds

By Carla Tardi · July 26, 2022 · 10 minute read

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A Beginner's Guide to Investing in Index Funds

Index investing is a passive investment strategy in which, typically, you buy and hold assets for the long term. As such, index investing has become a popular addition to retirement vehicles, like 401(k)s and 403(b)s. With index investing, instead of purchasing individual stocks, you buy an index — an exchanged traded fund (ETF), or a mutual fund that represents a particular market sector (technology, for instance) or a broad benchmark, like the S&P 500 index.

Index investing seeks to replicate the performance of the sector or benchmark it follows. Because this product is already composed of the companies or sectors whose performance it aims to mimic, once you purchase an index fund, there’s not much trading going on; it’s already set up to perform in line with its index. As such, it’s considered passive investing — a buy-and-hold play.

On the other hand, an actively managed fund is guided by a professional portfolio manager (PM), who makes decisions based on their experience and knowledge. Rather than wishing to generate returns in line with a sector or benchmark, actively managed funds seek to beat the market. They appeal to those who want to make a profit in the near term by outperforming the market. In an effort to do so, PMs watch their funds’ underlying assets carefully and may adjust their holdings aggressively, or as needed to beat the market.

We’ll come back to active versus passive investing later.

There are many ways to approach investing. Some require a significant amount of time and involvement, while others need less effort on your part. It’s important to be aware of your objectives and tolerance for risk, so you can choose which types of investments fit with your goals and are in line with your temperament.

In this article, we discuss the nature of index investing, its potential advantages and disadvantages, and how best to use this strategy.

What Are Index Funds?

An index fund is a type of mutual fund or exchange traded fund (ETF) that tries to track the performance of a specific broad sector of the market — like technology — or a market index — like the Standard and Poor’s (S&P) 500. The idea is to try to replicate the chosen benchmark’s performance as closely as possible. Because index funds seek to replicate an index as closely as possible without trying to change it, you may hear people refer to indexing as being passive.

There are index funds for the U.S. bond market, the U.S. stock market, international markets, and others. Index investing is the process of investing in these index funds.

How Do Index Funds Work?

An index fund is a mutual fund or ETF that aims to mimic the overall performance of a particular market. The fund includes multiple stocks or bonds and is bought and sold like it’s a single investment. Index funds follow a benchmark index, such as the S&P 500 or the Nasdaq 100.

When you put money in an index fund, that cash is invested in all the companies that make up the particular index, which adds more diversity to your portfolio than if you were buying individual stocks. The S&P 500 is one of the major indexes that tracks the performance of the 500 largest companies in the U.S. Investing in an S&P 500 fund means that your investments are tied to the performance of a wide range of companies.

Because the goal of index funds is to mirror the same holdings of whatever index they track, they are naturally diversified and thus generally have a lower risk profile than do individual stocks. Market indexes tend to have a good track record, too. Though the S&P 500 certainly fluctuates, historically, it has historically generated an approximate 10.5% average annual return for investors; from its inception in 1957 through 2021. Just remember that — as with all investments — future returns are not guaranteed.

Index Investing vs Active Investing

Active investing typically involves in-depth research into each stock purchase, as well as regularly watching the market in order to time buys and sells. Passive investing strategies either aim to bring in passive income or to grow a portfolio over time without as much day-to-day involvement. Index investing is a passive strategy which looks to match the returns of the market it seeks to track.

Index investing is a form of passive investing. Index investors don’t need to actively manage the stocks and bonds investment as closely since the fund is simply copying a particular index. This is why index funds are known as passive investing — and it’s what sets them apart from mutual funds.

Mutual funds are actively managed by portfolio managers who choose your investments. The goal with mutual funds is to beat the market, while the goal with index funds is to match the market’s performance. Because index funds don’t require daily human management, they have lower management costs (called expense ratios) than mutual funds. The money saved in fees by investing in an index fund instead of a mutual fund can save you lots of money in the long term and help you to make more money.

A common strategy for many investors who have a long investment horizon is to regularly invest money into an S&P 500 index fund and watch their money grow over time.

Growth of Index Investing

Index investing started in the 1970s, when economist Paul Samuelson claimed that stockpilers should go out of business. Samuelson believed that even the best PMs could not usually outperform the market average. Instead of working with portfolio managers, Samuelson suggested that someone should create a fund that simply tracked the stocks in the S&P 500.

Two years later, struggling firm Vanguard did just that. The fund was not widely accepted, and neither was the concept of index funds. Index investing has only become widely popular in the past two decades as data continues to reaffirm its merits.

Index investing has been gaining in popularity in recent years. Since 2010, actively managed funds have dropped from comprising 75% of all mutual fund assets to just 51%, as passively managed funds have grown to 49%. It’s reached the point where some industry observers may believe that the craze for passively managed index funds could even be dampening capitalism’s greatest innovation driver: competition.

Popular Indexes Include

•   S&P 500 Index

•   Dow Jones Industrial Average

•   Russell 2000 Index

•   Wilshire 5000 Total Market Index

•   Bloomberg Barclays Aggregate Bond Index

Popular Index Funds Include

•   Vanguard S&P 500 (VOO)

•   T. Rowe Price Equity Index 500 (PREIX)

•   Fidelity ZERO Large Cap Index Fund (FNILX)

•   Standard and Poor’s Depository Receipt (SPDR) S&P 500 ETF Trust (SPY)

•   iShares Core S&P 500 ETF (IVV)

•   Schwab S&P 500 Index Fund (SWPPX)

Potential Advantages of Index Investing

The popularity of index investing is well-founded, as it has a number of benefits.

Can Be Easier to Manage

It might seem as though active investors would have a better chance at seeing significant portfolio growth than index investors, but this isn’t necessarily the reality. Day trading and timing the market can be extremely difficult, and may result in huge losses or underperformance. Active investors might have one very successful year, but the same strategy may not work for them over time.

Some individual investors who are not professionals just don’t have the time to learn the ins and outs of financial markets, let alone stock picking. Further, taking a hands-off approach to investing could eliminate many of the biases and uncertainties that arise in a stock-picking strategy.

Empirical research consistently demonstrates that index investing tends to outperform active management over the long term. Boston financial services market research firm, Dalbar, Inc., confirms that the average investor consistently earns below-average returns. For instance, for the 12-months ended Dec. 31, 2021, the S&P 500 posted a market return of 28.71%, while the average equity fund investor returned 18.39%.

SoFi users can take advantage of index investing by setting up an automated investing strategy to rebalance and diversify portfolios.

Lower Cost of Entry for Multiple Stocks

If you only have a small amount of money to start investing, and you choose to invest in individual stocks, you may only be able to invest in a few companies. With index investing, you gain access to a wide portfolio of stocks with the same amount of money.

Also, index investing doesn’t necessarily require a wealth manager or advisor — you can do it on your own. The taxes and fees tend to be lower for index investing because you make fewer trades, but this is not always the case. Always be sure to look into additional fees and costs before you make an investment.

Portfolio Diversification

One of the key tenets of smart investing is diversifying your portfolio. This means that rather than putting all of your money into a single investment, you divide it up into different investments. By diversifying, you may lower your risk because if one of your investments loses value, you still have others. At the same time, if an investment significantly goes up in value, you still typically benefit.

Index funds give you access to numerous stocks all within a single investment. For example, one share of an index fund based on the S&P 500 can give you exposure to as many as 500 different companies for a relatively small amount of money.

Index Investing Is Fairly Passive

Once you decide which index fund you plan to invest in and how much you will invest, there isn’t much more you need to do. Most index funds are also fairly liquid, meaning you can buy and sell them relatively easily when you choose to.

Potential Disadvantages of Index Investing

Although there can be upsides to investing in index funds, there can also be downsides and risks to be aware of.

Index Funds Follow the Market

Index funds track with the market they follow, whether that’s the U.S. stock market or another market. So, if the market drops, so does the index fund that’s trying to replicate that market’s performance.

Index Funds Don’t Directly Follow Indexes

Although index funds generally follow the trends of the market they track, the way they’re structured means that they don’t always directly track with the index. Because index funds don’t always contain every company that’s in a particular index, this means that when an index goes up or down in value, the index fund doesn’t necessarily act in exactly the same way. This is why it’s important to understand how specific index funds seek to track their underlying index.

Index Investing Is Best as a Long-Term Strategy

Because index funds mostly track the market, they do tend to grow in value over time, but they are certainly not get-rich-quick schemes. Returns can be inconsistent and typically go through upward and downward cycles.

Some investors make the mistake of trying to time the market, meaning they try to buy high and sell low. Investing in index funds tends to work the best when you hold your money in the funds for a longer period of time; or if you engage in as in dollar-cost-averaging. Dollar-cost-averaging is a method of investing the same amount consistently over time to take advantage of both high and low points in market prices.

Choosing an Index to Invest in

The name of a particular index fund may catch your eye, but it’s essential to look at what’s inside an index fund before investing in it. Determine what your short- and long-term goals are and what markets you are interested in being a part of before you begin investing.

There are both traditional funds and niche funds to choose from. Traditional funds follow a larger market, such as the S&P 500 or Russell 3000. Niche markets are more focused and may contain fewer stocks.

They may focus on a particular industry. Typically, a good way to start investing in index funds is to add one or more of the traditional funds first, then add niche funds if you feel strongly about their growth potential.

Index Funds Are Weighted

Depending on which index fund you invest in, it may be weighted. For example, the S&P 500 index is weighted based on market capitalization, meaning larger companies like Amazon and Meta (formerly Facebook) hold more weight than smaller ones.

If Meta’s stock suddenly goes down, it may be enough to affect the entire index. Other indexes are price weighted, which means that companies with a higher price per share will be weighted more heavily in the index. Another form of index weighting could be equal-weight or weights determined by other factors, such as a company’s earnings growth.

Less Flexibility

If you actively invest in individual stocks, you can usually choose exactly how many shares you want to buy in each company. But when you invest in index funds, you have less flexibility. If you’re interested in investing in a particular industry, there may not be an index fund focused solely on that.

How to Get Started With Index Investing

To invest in an index, investors typically purchase exchange traded funds that seek to track an index. Some funds include all the assets in an index, while others only include certain assets.

Prior to investing in any index fund, be sure to look into the details of how the fund works. You can find information about what is contained in the fund, how it is weighted, its fees and quarterly earnings, and other details on the fund’s website. You also can get that data via a financial advisor, or from the Electronic Data Gathering, Analysis, and Retrieval system (EDGAR) , which the U.S. Securities and Exchange Commission (SEC) oversees.

Alternatives to Index Investing

Despite the fact that index investing has grown in popularity over the past two decades, some analysts are now bringing up additional downsides and alternatives that investors may want to consider.

The stock market includes companies from many industries, some of which investors are moving away from investing in. Oil and gas companies, pesticide companies, and others — which some people could consider harmful to the environment or human populations — may be included in an index fund. As the economy moves away from these industries, these types of companies may not perform as well, and as an investor you may not want to support them financially.

Some new index funds are being formed around the principles of sustainability and positive social impact. You may also be interested in impact investing and other types of ETFs and mutual funds that focus on specific industries that affect society positively.

Building Your Portfolio

Whether you’re interested in investing in index funds or in hand-selecting each stock, it’s important to keep track of your portfolio and current market trends.

Once you know what your investment goals are, the SoFi Invest online investing platform can be a great tool to build your portfolio and track your finances. And, as we discussed above, with SoFi Automated Investing, you can easily add index fund ETFs to your portfolio, all on your phone if you choose. The automated investments are pre-selected for you, so you simply need to decide which funds to invest in, and how much you want to invest. Or, if you prefer to hand-select each stock in your portfolio, you can use the SoFi Active Investing self-directed brokerage platform.

SoFi has a team of credentialed financial advisors available to answer your questions and help you reach your goals. You only need a $1 to get started.

Find out more about how you can use SoFi Invest to meet your financial goals.

FAQ

What happens when you invest in an index?

When you invest in an index, you’re investing in not one stock, but in a collection of stocks (or other asset types, like bonds). The number of assets in an index can range from the tens to the hundreds. And they usually have something in common, be it their capitalization (large or small cap); their sector (tech or healthcare), and so on.

Are indexes safe investments?

Investing in the capital markets always entails a degree of risk; there are no guarantees, and no investment is 100% safe. That said, investing in an index fund can entail less risk than owning a handful of individual company stocks because index funds are diversified. That doesn’t mean you can’t lose money, but an index generally fluctuates a lot less than an individual stock. Index funds are only as stable as their underlying index.

What does index mean in investing?

In investing, the term “index” refers to the basket of assets (stocks, bonds, etc.) that comprise an index fund.


Photo credit: iStock/PixelsEffect

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Investment Risk: Diversification can help reduce some investment risk. It cannot guarantee profit, or fully protect in a down market.
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