As a first-time investor, you’re often guided to index funds as the place to start your wealth-building journey. But how do you even begin to figure out which of the many, many index fund options are right for you? Let’s take a look at some index fund basics that can help you orient yourself.
As we’ve explained before, an index fund is a collection of investments you buy in one package. That package—the fund—tries to mirror a certain performance level for that corner of the financial market. “Instead of having to pick individual stocks of companies, and having to research those companies, you gain exposure to a bundle of stocks or bonds or whatever security,” Anjali Pradhan, CFA and investment coach at Dahlia Wealth, explained. Index funds can take away the stress of choosing specific stocks, and they usually cost much less than other investment vehicles.
(A quick note on ETFs vs. index funds, because sometimes the terms get interchanged: Pradhan explained that ETFs are traded on stock exchanges with prices that vary second by second like a stock. Index funds, on the other hand, are traded like mutual funds and are priced once a day by the investment firm.)
Portfolio diversity without hassle
All index funds have a “type,” so to speak, you can still diversify your portfolio within index funds. “Little, big, any market that’s out there, there’s more and more of a chance there’s some index fund out there for you,” said Rand Spero, president of fee-only financial planning firm Street Smart Financial.
Types of index funds
Here are just a few you might see:
Total stock market: Covers a broad swath of an entire market, like the Dow Jones Industrial, for instance.
S&P 500: The 500 companies that the Standard & Poor’s Index decides to measure (usually, the largest in the U.S.).
Market capitalization: Companies get grouped by their value. But they’re also categorized by size, so you’re getting a grouping of companies on a relatively similar playing field. The Motley Fool has a breakdown of how companies are broken into large-cap, small-cap, and other brackets.
International markets: Index funds aren’t just for U.S.-based companies. You can choose funds that track international markets based on whatever measurement you’re looking for (company size, location, etc.)
Target date fund: You specify when you think you’ll retire and the fund chooses a mix of stocks and bonds that matches what it thinks is appropriate for someone your age. “It’s one size fits all,” Spero said. “Need a hat? Here’s a hat. But what’s in it?” It’s not one fund, he explained. Instead, there are index funds packaged within that target date fund.
Growth index: These indexes have companies that are expected to grow faster than the overall market, says The Motley Fool.
Value indexes: Made up of company stocks that are trading at low prices compared to the company’s earnings.
Socially-responsible funds: Don’t want your investment portfolio to include liquor companies, gambling, or or fossil fuels? There are a variety of funds with social and environmentally conscious lineups.
Dividend-focused funds: Some funds take profits for the year and cut you a check for a percentage, Spero explained. (Others take the money and reinvest it.)
Sector-based funds: Want to focus on real-estate? Entertainment companies? Retail? There’s an index fund for whatever industry interests you.
Where to get started with index funds
All those options are nice—that is, unless they stress you out because there are so many. But don’t let their diversity stop you from investing in index funds.
“Start out with basic core [index funds],” Spero said. “S&P 500, total market index. Keep it simple, straightforward, and broad, and don’t get too clever,” he said.
Mabel Nunez, founder of stock market investing education company Girl$ on the Money, suggested five metrics to look into before choosing an index fund. We’ve added our own tips to each one of her check points:
Expense ratio (look for those that charge less than 0.25%)
Performance over time: Ups and downs are normal, but make sure you’re comfortable with those fluctuations.
Performance compared to a standard S&P 500 fund (You can check this on Morningstar)
Holdings: How is the index fund investing the money? (Refer to the list above to make sure you’re comfortable with the holdings)
Turnover ratio: “How often do the stocks inside the index funds get sold and replaced by something else?” Nunez said. “The lower the better when it comes to this. High turnover ratios can equal significant expenses that are then transferred to the investor.”
Once you’ve chosen an index fund (or two or three), don’t forget to check on your selections once a year. Your taste in investments may change over time, and you may find that today’s good fit may not be the right one for you a few years from now.
Index funds are friendly to new investors, but they aren’t the only path to building wealth. Don’t let them give you a false sense of security, Spero warned “It’s not a life preserver,” he said. “It’s a relatively good product to start your investing process, but it’s not an end destination.”
In other words, index funds are important, but so are savings vehicles like your 401(k) and emergency fund. It’s important to build a diversified investment and savings strategy over time, but even more important? Getting started now, no matter how small your first step is.