A Beginner’s Guide to Index Funds: Step-by-Step Tutorial

What Is an Index Fund?

An index fund is a portfolio of stocks (usually an entire market index) that is bought and sold as a single product. The S&P 500 is an example of a market index, representing 500 of the largest publicly traded companies in the United States. Instead of trying to beat the market by buying what they think will go up and selling what they think will go down, index funds simply own a representative slice of the entire index.

So when people say “the market was up 8% this year,” what they really mean is that an index like the S&P 500 was up 8% and an index fund that tracks that index would’ve returned close to 8% as well, minus a tiny fee. Pretty simple.

Why Index Funds Are Great for Beginner Investors

Why Index Funds are Awesome For Beginners (& Experts)

Don’t put all your eggs in one basket. Purchasing an individual stock ties the health of your investment to the success or failure of a single company. Index funds own a small piece of hundreds of companies at once. When you diversify this way, poor performance by a single stock doesn’t hurt your returns very much (if at all).

Cheap fees. Index funds have minuscule fees because they simply track an index. They don’t pay expensive analysts to pick stocks. Their fees, called the “expense ratio”, can often be under 0.1% per year. Many actively managed funds charge 1% or more.

Proven track record. Studies have repeatedly shown that most active mutual funds fail to outpace the market indexes they’re benchmarked against over time. Some of the most well-respected financial writers advise new investors to choose index funds as a simple and inexpensive way to start investing.

It’s easy. There’s no homework. Forget researching individual stocks or worrying about earnings announcements and market “timing.” Choose a fund, set up automatic contributions, and check back once in a while to watch your money grow.

How Do Index Funds Make Money?

Investing: Wait, How do Index Funds Make Money?!

When you invest in an index fund your money will earn returns in two ways. The first way is from the prices of the stocks within the index going up over time (known as appreciation). The second way is from dividends. When public companies earn a profit, they can choose to either reinvest that profit back into the company, or pay it out to shareholders in the form of dividends. When you own a piece of the company via an index fund, you’ll get a small slice of those dividends too. Most index funds will automatically reinvest those dividends into more of the index fund for you. Over long enough time frames, both appreciation and reinvested dividends will help your investments grow.

Types of Index Funds Every Beginner Should Know

Popular Types of Index Funds

Total Market Index Funds: Includes small cap, mid cap, and large cap (“small,” “medium,” and “large” refer to company size by market capitalization). If you only own one fund this is almost certainly what you should own.

S&P 500 Index Funds: Tracks 500 largest US companies. Combined, those 500 companies make up about two-thirds of the total market value of US public companies.

International Index Funds: Instead of US companies, an international index fund will own companies from other countries. For example, an “international developed markets” fund might own companies from Europe, Australia, Canada but not Mexico or China.

Bond Index Funds: Bonds are essentially loans that you give to the government or a corporation. Over time, they’ll pay you back the original amount plus interest. Bond index funds behave very differently than stock index funds. They’re generally much more stable but offer lower returns. They can be a good way to balance your portfolio risk.

Sector Specific Index Funds: Rather than own a wide swath of the market these funds focus on particular sectors like technology, health care, or energy. They’ll have more volatility than total market funds but less than single stocks.

Index Funds vs ETFs: What's the Difference?

Index Funds vs ETFs: Which Should You Invest in?

There is a lot of overlap between index funds and ETFs (exchange traded funds). In fact, almost everything in this article applies to index ETFs as well. The difference is that ETFs trade throughout the day just like stocks, whereas mutual funds are only priced once at the end of the day. They can both be bought and sold through almost any brokerage account. The choice between index funds and ETFs doesn’t matter much for beginner investors.

Step-by-Step Guide to Investing in Index Funds

Step 1: Determine What Type of Investment Account to Open

Do you have access to a retirement account at work that matches contributions? If so, that’s where you should start. Investing enough to get the full employer match is essentially free money. If you don’t have that opportunity, or once you’ve filled that, consider whether you’d prefer a tax advantaged retirement account (IRA) or a regular taxable brokerage account. They each have pros and cons.

Step 2: Choose the Right Brokerage Account

Many brokers offer index funds and ETFs now with no commission to trade and no account minimums. You pay taxes a little differently depending on whether you contribute to an IRA or a brokerage account, but past that the decision is mostly about which website and interface you prefer.

Step 3: Select the Best Index Fund

For most beginners, simply choosing one total market or S&P 500 index fund will suffice. You may also want to pair it with a bond index fund for some stability. Your specific allocation will depend on your risk tolerance and how long you plan to invest.

Step 4: Set Up Automatic Investing

Having money automatically moved from your bank account into your fund will not only help you resist the urge to sell during market dips, but it also lets you start investing smaller amounts than you might think. Start with whatever you’re comfortable with and remember you can always increase it later.

Step 5: Stay Invested for the Long Term

This is the hardest step for most people. You’re invested, now just forget about it. Ups and downs are normal and long-term investing works on getting you to wait out the downturns. Resist the urge to market “timing” by checking constantly or selling low and you’ll be fine.

How Risky Are Index Funds?

Well, that depends. If you own an S&P 500 index fund your investment will plummet right along with the stock market during downturns. But that doesn’t mean your investment is failing. Stock-index funds will always have ups and downs, that’s normal. Unless you need the money within the next three to five years you should be fine, but consider speaking with a financial advisor for personalized advice. Bond index funds are less volatile but offer lower returns. They can help smooth out some of the highs and lows of stock index funds.

Example of Long-Term Index Fund Growth

An Example of Index Fund Growth Over Time

$300 per month invested at 8% annual gains will turn into nearly $1 million by the time you retire. ($300 per month may not seem like a lot, but remember you can start small and increase your contribution later!)

$300 x 12 months = $3,600 per year

$3,600 at 8% per year for 30 years = $551,948

$3,600 at 8% per year for 40 years = $998,848

That’s not actually guaranteed to happen. But if you invested consistently for 30 or 40 years and the market provided historical average returns (about 7–10% before inflation each year over decades at a time) you’d come pretty close. You also get bonuses if your fund pays dividends because those get reinvested each month as well.

Keep in mind that this is a simplified example and your actual returns will vary. Market performance will be slightly higher or lower during your investing years. You may not contribute an equal amount every month (though you should!). You’ll probably pay fees too. But if you contribute regularly for multiple decades you should come out rich regardless of the ticker symbol dance party happening along the way.

Frequently Asked Questions About Index Fund Investing

How much do I need to start?

You can start investing with index funds with less than $100. Seriously.

Are index funds guaranteed to grow?

No investment is guaranteed but historically stock index funds have always gone up over longer time periods. By owning very small pieces of many different companies, index funds minimize the impact of any single company underperforming.

What’s the difference between an index fund and a mutual fund?

Technically, all index funds are mutual funds. Mutual funds are any funds that are professionally managed for groups of investors. Index funds are mutual funds that simply track an underlying index rather than trying to outperform it.

How often should I check my investments?

As often as you want, though probably not daily. Long-term investing is a marathon, not a sprint. Check quarterly or even yearly for most investments. More frequent monitoring is generally emotional than it is practical.

Conclusion

That’s the basics of how to invest in index funds. Remember – start small, keep it simple, and check back years later to find out how much money you’ve made.