Index Funds for Beginners: How They Work and How to Start
In this guide
- What is an index fund?
- Why index funds work so well
- How much do fees really matter?
- Mutual fund vs. ETF: which version should you buy?
- How to choose your first index fund
- How to buy your first index fund in 30 minutes
- What returns can you expect?
- Mistakes to avoid with index funds
- Frequently asked questions
- Your first index fund checklist
Warren Buffett has repeatedly said that for most people, a low-cost S&P 500 index fund is the most sensible way to invest. That’s a striking recommendation from one of the most successful stock pickers in history, and it captures why index funds have become the default choice for millions of investors.
If you’re new to investing, index funds are probably the simplest, cheapest and most reliable way to start. Below you’ll learn what they are, why they work, how to compare them and exactly how to buy your first one.
What is an index fund?
An index fund is a mutual fund or exchange-traded fund (ETF) that tries to match the performance of a market index instead of beating it.
A market index is a list of investments that represents part of the market. A few well-known examples:
| Index | What it tracks | Approximate number of holdings |
|---|---|---|
| S&P 500 | 500 large US companies | About 500 |
| CRSP US Total Market | Nearly the entire US stock market | Several thousand |
| Total international stock indexes | Companies outside the US, developed and emerging markets | Several thousand |
| Bloomberg US Aggregate Bond | Investment-grade US bonds | Thousands of bonds |
When you buy one share of an S&P 500 index fund, you own a tiny slice of all 500 companies in it. If the index rises 10% in a year, your fund rises by about the same amount, minus its small annual fee.
Why index funds work so well
1. Instant diversification
Owning hundreds or thousands of companies means no single company can sink your portfolio. If one company goes bankrupt, it’s a small fraction of your holdings. Building that kind of diversification by buying individual stocks would take a lot of money and effort.
2. Very low costs
Index funds don’t pay teams of analysts to pick stocks. They simply follow the index, so their costs are low. Many broad index funds charge expense ratios under 0.10% a year, and some charge as little as 0.03%. Many actively managed funds charge several times more.
3. Strong long-term results
Research from S&P Dow Jones Indices, published in its regular SPIVA reports, has consistently found that most actively managed US stock funds trail their benchmark index over 10 and 15-year periods. The main reason is simple: higher fees and trading costs eat into returns year after year.
4. Easy to understand and maintain
You don’t need to research companies, follow earnings reports or decide when to buy and sell. You pick a fund, contribute regularly and let it grow.
How much do fees really matter?
The expense ratio is the percentage of your investment the fund charges each year. Small differences compound into large sums over a career.
| Expense ratio | Annual cost on $10,000 | Annual cost on $100,000 |
|---|---|---|
| 0.03% | $3 | $30 |
| 0.20% | $20 | $200 |
| 0.75% | $75 | $750 |
| 1.00% | $100 | $1,000 |
Over 30 years of monthly investing, a one-percentage-point difference in fees can reduce your ending balance by more than 15%. Our guide on how to start investing shows a worked example.
Mutual fund vs. ETF: which version should you buy?
Most index funds come in two forms. Both are good choices.
| Index mutual fund | Index ETF | |
|---|---|---|
| How it trades | Once a day at the closing price | Throughout the day like a stock |
| Minimum investment | Sometimes $1,000–$3,000; some have none | Price of one share, or as little as $1 with fractional shares |
| Automatic investing | Easy at most brokerages | Available at many brokerages |
| Tax efficiency in taxable accounts | Good | Usually slightly better |
In a 401(k), you’ll typically see index mutual funds. In an IRA or brokerage account, either works. Pick whichever your brokerage makes easiest to buy automatically.
How to choose your first index fund
Option 1: A total US stock market or S&P 500 fund
A single US stock index fund gives you broad exposure to American companies. The S&P 500 covers large companies; a total market fund adds mid-size and small companies too. Their long-term returns have been very similar.
Option 2: A target-date index fund
A target-date fund holds several index funds (US stocks, international stocks and bonds) in one package and gradually becomes more conservative as its target year approaches. If you want one fund and nothing else, choose an index-based target-date fund with the year closest to when you plan to retire.
Option 3: The three-fund portfolio
A popular do-it-yourself approach uses three funds:
- US total stock market index fund
- International stock index fund
- US bond market index fund
You choose the mix based on your age and risk tolerance. A young investor might hold 60% US stocks, 30% international stocks and 10% bonds, for example. You rebalance once a year to keep the proportions on target.
What to check before you buy
- Expense ratio: lower is better; for broad funds, aim for under 0.20%.
- What index it tracks: make sure it’s broad (S&P 500, total market, total international, total bond) rather than a narrow sector.
- Fund size and history: large, established funds from major providers tend to track their index closely.
- Minimums and trading fees at your brokerage.
How to buy your first index fund in 30 minutes
- Choose the account. If your employer offers a 401(k) match, start there. Otherwise, open a Roth IRA or a taxable brokerage account at a low-cost brokerage.
- Fund the account. Link your checking account and transfer money. Any amount works; many brokerages let you start with $1.
- Search for the fund by name or ticker symbol.
- Place the order. For an ETF, choose a dollar amount (fractional shares) or number of shares. For a mutual fund, enter a dollar amount.
- Turn on automatic investing. Schedule a recurring purchase every payday or month, and turn on dividend reinvestment.
That’s it. You’re an index fund investor.
What returns can you expect?
Nobody can promise returns. Historically, the US stock market has returned roughly 10% a year on average over very long periods before inflation, but individual years range from big gains to losses of 30% or more. Many planners use more conservative assumptions, such as 6–7% a year, when projecting the future.
The key is time. Over short periods, anything can happen. Over decades, broad stock index funds have historically rewarded patient investors. Use our compound interest guide to see how regular investing can grow.
Mistakes to avoid with index funds
- Selling during a downturn. The index will fall sometimes. Selling locks in losses; staying invested gives the market time to recover.
- Owning five funds that hold the same thing. An S&P 500 fund and a total US market fund overlap heavily. More funds doesn’t mean more diversification.
- Chasing narrow or trendy index funds. Funds that track a single sector or theme are far less diversified than broad market funds.
- Leaving money uninvested. Transferring money into an IRA or brokerage account isn’t the same as buying the fund. Check that your cash is actually invested.
- Ignoring international stocks entirely. Many investors hold some international exposure for added diversification.
Frequently asked questions
Are index funds safe?
Index funds are diversified, which reduces the risk of any single company hurting you, but they still go up and down with the market. A stock index fund can lose a significant portion of its value in a downturn. They’re best for money you won’t need for at least five years.
Can you lose money in an index fund?
Yes, in the short term. If you sell after the market falls, you lose money. Over long periods, broad stock indexes have historically recovered from declines, but past performance doesn’t guarantee future results.
How much money do I need to start investing in index funds?
Very little. Many ETFs can be bought as fractional shares for $1 or more, and some index mutual funds have no minimum.
Is an S&P 500 fund enough on its own?
It’s a solid core holding, but it only covers large US companies. Many investors add international stocks and, as they get closer to retirement, bonds. A target-date fund handles this mix for you.
Should I pick individual stocks instead?
Picking stocks is riskier and requires much more research, and most professionals fail to beat the index consistently. If you enjoy it, many investors keep stock picking to a small portion of their portfolio, with index funds as the core.
Your first index fund checklist
Index funds give you broad diversification, very low costs and market returns with minimal effort. Choose a broad US or total-market fund, a target-date fund or a simple three-fund portfolio, keep fees low and invest automatically.
Get started: Open your account, buy one broad, low-cost index fund this week and set up an automatic monthly purchase. Once that’s running, the hardest part is simply leaving it alone. If you’re still deciding between doing it yourself and using an automated service, our comparison of robo-advisors and DIY investing can help.