What Is an Index Fund and Why Should I Invest in One?

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If you’re new to investing, you may have heard about index funds but maybe you’re not exactly sure what they are.

In this article, we’ll explain what an index fund is, how you can invest in one, what the associated investment costs can be and more.

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Key features of index funds include low costs, diversification of your money across hundreds or thousands of companies, passive investing that doesn't involve stock picking and more.

What Are Index Funds?

Index funds are a basket of stocks that mimic certain stock indexes like the S&P 500, the Dow Jones Industrial Average (DJIA) or any of a number of other popular ones.

When you buy an index fund, your money is split among the 500 companies in the S&P 500 or the 30 companies in the Dow, as just two possible examples. So you have a basket with little slices of potentially hundreds or even thousands of companies, and you own a fractional share of each — all in one neat little investment.

“Instead of you buying an investment like an individual stock or a mutual fund where some brainiac tries to figure out what to buy, what to sell, how much of it to get… well, in an index fund it’s really simple; you just buy all the big companies in the country,” money expert Clark Howard says.

How Do I Invest in Index Funds?

Investing in index funds is easy. They’re widely offered by low-cost discount brokerage houses such as Vanguard, Fidelity, Schwab and others.

If you have a 401(k) retirement plan or something similar, chances are you already have access to index funds.

But you can also purchase index funds and own them in any number of investment vehicles such as a traditional IRA or a Roth IRA.

The Roth IRA is one of Clark’s favorite investment vehicles because of the favorable tax treatment. We’ve got full details on how to open a Roth IRA here.

How Much Does It Cost to Invest in an Index Fund?

The cost of index funds varies by provider, but in general, the costs are low. Since these are not actively managed investments, you’re never paying for someone to pick the stocks.

Here’s a look at some sample fees across similar products designed to track the S&P 500 — giving you access to the 500 largest public U.S. companies:

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Investment (Ticker Symbol) Expense Ratio Minimum Invest Required
Vanguard 500 Index Fund Admiral Shares (VFIAX) 0.040% $3,000
Fidelity 500 Index Fund (FXAIX) 0.015% No minimum
Schwab S&P 500 Index Fund (SWPPX) 0.020% No minimum

As you can see, it doesn’t cost a lot to invest in an index fund. The Vanguard option charges you four pennies out of every $100 you invest. Fidelity charges just a little more than a penny out of every $100. And Schwab charges you just two cents on every $100 you put into the market.

But did you know it’s possible to invest in index funds for free? In 2018, Fidelity introduced a slate of no-fee index funds — the Fidelity ZERO funds:

With zero fees, every single penny you invest goes toward building long-term wealth! And there’s no minimum to get started with these index funds. So far, Fidelity’s move to zero-fee index funds has yet to be matched by its competitors.

Clark’s Investing Rules of Thumb

Clark Howard routinely talks about “the four Ds” when it comes to investing: discount, dollar-cost averaging, diversification and dull.

Discount

Clark wants you to pay 0.1% or less for your investments. As we’ve seen in this article, there are a variety of index funds that cost considerably less than that.

Dollar-cost averaging

This is a fancy way of talking about contributing the same amount of money on a set schedule to an investment — as you would through an employer’s 401(k) plan with a weekly or biweekly payroll deduction.

By doing this, you never overbuy at the peak of market values and you never buy too little when stocks are “on sale” during times of financial panic. Simply put, dollar cost averaging is the Goldilocks formula for building wealth over the long haul.

Diversification

Third up is diversification. As the name suggests, this is the idea of not putting all your eggs in one basket.

Buying an index fund meets this criterion by definition because you’re buying a whole group of securities spread out across hundreds or thousands of companies.

Dull

Finally, “dull” is an investing mantra for the ages. As we’ve shown here, an index fund doesn’t chase the hot companies. Instead, it owns tiny slices of hundreds or thousands of publicly traded companies.

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Final Thought

Index funds are a great way to own a wide range of investments all in one basket for a very low cost. As such, they make an ideal cornerstone when you’re trying to build a portfolio for retirement.

“Remember that the goal should be financial security for your life. And you do that not by betting the farm on one company,” Clark says. “I want you betting on the future of capitalism, not the future of a single company.”

Meanwhile, if you have additional questions about investing and saving for retirement, you can call our Consumer Action Center for free advice.

More Investing & Retirement Articles on Clark.com

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