So many of us tout the advantages of index fund investing. And for good reason! But, if you are like I was just a couple of years ago, I had no clue how to actually buy index funds.
So, this is your guide to how to buy index funds for beginners!
First, a review
Index funds are a collection of stocks designed to mirror an overall “index” of the stock market. For instance, there are index funds that mirror the entire stock market by including all of the stocks in the U.S. market. Other index funds mirror the S&P 500 index and so on.
Why is this a good thing?
Well, investing in the stock market can seem really risky and intimidating.
That is until you realize that the overall stock market has always gone up over any long term period. (More in depth discussion about this can be found here.)
That means that if you could just find a way to invest broadly in the overall stock market over a long term, you would make a lot of money with your investment.
And that’s exactly what index funds are designed to do!
In short, investors should consider adding index funds because it is a way to invest in the overall stock market. And the overall stock market over the long term has been a safe investment.
And to make things even better, there are index funds of bonds and similar things to index funds for real estate called Real Estate Investment Trusts (REITs).
What are the pros of index fund investing?
The pros of index funds are that they are relatively “hands off.” You buy index funds and hold on to them for the long term, regardless of what the market does in the short term.
They also have low fees which means more money in your pocket, not the brokerage’s.
And the cons?
The cons of index funds are that their return generally equals the market average. Many advisors will claim to be able to beat this average and use this as a downside to index funds.
However, remember that studies have shown that index funds beat active investing strategies 80% of the time, favoring index funds.
Score another point for index funds…
How to buy index funds
Step 1 – Figure out your asset allocation
You’ll want to know what percentages of stocks, bonds, real estate, etc. you want in your portfolio. (Hopefully you are not including too much “etc.” in your portfolio…like these 3 investments that I generally recommend staying away from…)
You can also get fancy and break up your stock investments into U.S. and international stocks. Or use other factors like value versus growth, etc.
(My recommendation is to keep it simple…)
Anyway, once you figure this out, you know how much and what kinds of index funds to buy.
This is a complete guide to figuring out your asset allocation.
Step 2 – Decide what index you want to mirror
Ok, let’s say you know you want 70% of your asset allocation in U.S.stocks. And you are going to invest $10,000 (*Arbitrary round number).
So, you want to buy $7,000 worth of broadly diversified, low cost index funds representing the U.S. stock market.
But before you actually buy, you need to figure out what index you want to mirror. That way you can pick the right index fund.
In general, choosing the overall market is the best strategy for beginners (or experts).
In this case, a total stock market index fund or an S&P 500 index fund is a great option. For example, the VTSAX fund by Vanguard does an excellent job of mirroring the overall U.S. stock market. That is a great fund for new investors to begin with.
Step 3 – Find an index fund that does a good job of mirroring that index
Ah, another step before buying. You’ll want to confirm that the index fund you chose actually does a good job of mirroring the index that you want it to mirror.
In some cases, like with VTSAX, I can tell you that it does exactly what it is supposed to do – mirror the overall U.S. stock market.
But for some S&P 500 index funds with various brokerages (like the ones you may have available in your retirement accounts), the index fund doesn’t actually mirror the S&P 500 index so well.
In the prospectus of an index fund, it will list the percentage to which it follows its index. So, check this for the index funds you’ve chosen to invest in.
If it is an S&P 500 index fund with a 95% correlation to the S&P 500 index, perfect!
If it has a 65% correlation, not so great. This means that the managers of the fund are trying to stock pick and time the market with 35% of this index fund. That means less winning, more fees, and more taxes for you.
Try to find a better index fund.
You can also use the Morningstar Portfolio X Ray tool to help with this.
N.B. Sometimes, you may be limited in the brokerages available to you in your retirement accounts. Maybe the only brokerage you can use only has an S&P 500 index fund with 65% correlation. This still may be worth investing in for the tax benefits of being in the retirement account.
Step 4 – Buy the dang thing!
Go to your brokerage of choice. Select the index fund that you have chosen. Put in the amount that you would like to order.
Rinse and repeat.
For the stock market index funds. The bond index funds. And for the REITs.
Congrats! You are now investing your money, building your wealth, and working towards your financial freedom!
If you’re ready to take the next steps, use my guide to help design your own written financial plan and check out my free webinar on the 12 Steps to Financial Freedom for Physicians!
What do you think? How did you buy your first index funds? What index funds do you own? Any advice for beginners? Let us know in the comments below!