How to Start Investing in Index Funds

Investing doesn’t need to be complicated to be effective. Index funds are designed to be easy to understand, generally affordable and built for long-term growth. That makes index funds a popular choice for both first-time investors and those with more experience. Index funds are a simple, powerful way to start building a diversified investment portfolio.

Let’s take a look at what index funds are, how they work and how you can add them to your portfolio in a way that fits your goals and comfort level.

What are index funds?

An index fund is a type of investment product that holds a collection of stocks, bonds or other assets. Index funds are designed to mirror the performance of a specific market index like the S&P 500 or the Dow Jones Industrial Average (DJIA). They do this by automatically following a set list of securities. That’s different than actively managed funds, where a fund manager handpicks investments.

Think of index funds like a gift basket. You’re buying a pre-filled basket that represents a broad slice of the market instead of choosing items one by one. One of the biggest advantages of index funds is that their built-in variety gives you the benefit of diversification across companies of different market-cap sizes (meaning the total value of all of a company’s available shares), including large-cap, mid-cap and small-cap firms. When your money is spread across a wide range of assets, you don’t have to depend on any single one to perform well.

Index funds don’t require active management, so they tend to come with lower fees than other types of investment products. That means more of your money stays invested and working for you over time.

How do index funds work?

Index funds generate returns in 2 main ways:

• Price appreciation. As the value of the assets in the index fund increases, so does your investment. This growth tends to mirror the growth of the index your fund tracks. For example, if the S&P 500 goes up 5%, an index fund that tracks it typically will rise by a similar amount. 
• Dividends. Many companies included in index funds make periodic payments to shareholders. Those dividends often can be automatically reinvested to help your money grow faster.

To see how index funds perform over time, look at the index the fund tracks. For context, the S&P 500 has delivered average annual returns of around 10% over long periods. Remember that returns vary from year to year and are not guaranteed.

The main types of index funds: mutual funds vs. ETFs

Index funds come in 2 main forms: mutual funds and exchange-traded funds (ETFs). Both give you access to a diversified basket of assets, but they work a little differently.

Mutual funds

Mutual funds pool money from many investors to purchase a collection of assets. They’re priced once per day—after the market closes—making them a great set-it-and-forget-it option. They’re especially well suited for retirement accounts like IRAs and 401(k)s. Some mutual funds do have minimum investment requirements.

ETFs

ETFs work similarly to index mutual funds, but they trade on the stock market throughout the day, similar to individual stocks. They typically have no minimum investment requirement beyond the price of a single share. They also tend to be more tax efficient than mutual funds, which makes them a popular choice for taxable investment accounts.

Are index funds right for you?

Index funds are a good investment option for a wide range of investors, but like any investment product, they’re not one size fits all. Here are a few things to consider before you get started.

4 things to consider before you invest in index funds

1. Your timeline. Index funds are best suited for long-term investing. The longer your money stays invested, the more time it has to benefit from compound growth and recover from short-term market fluctuations. If you’re saving for something in the next year or two, index funds may not be the right fit.
2. Your risk tolerance. Index funds are often considered lower risk compared with some other investments, but they can still rise and fall with the market and may outperform or underperform expectations in certain years. If you’re closer to retirement, you may want to consider funds that lean more heavily on bonds, which tend to be more stable.
3. Your fees. Index funds are known for their low expense ratios. That’s the annual fee you pay to own the fund. For example, if a fund has an expense ratio of 0.10%, you would pay $10 each year for every $10,000 you have invested. If a fund’s expense ratio is 0.6%, you would pay $60 each year for every $10,000 you have invested. Even small differences in fees can add up significantly over time, so research your options before you buy.
4. Your tax situation. ETFs tend to be more tax efficient than mutual funds. Think about whether you’re investing through a taxable brokerage account or through a tax-advantaged account like an IRA or 401(k) before you choose your investments. This can matter if you prefer a more self-directed or low-maintenance investing approach.

How to invest in index funds: a step-by-step guide

The 3 steps below explain how people commonly get started with index fund investing.

1. Choose your investment account

Before you can buy index funds, you need an investment account where you can hold them. A retirement account—like an IRA, 401(k), 403(b) or Thrift Savings Plan (TSP)—is a great option if you’re investing for the long term. A taxable brokerage account gives you more flexibility for other goals. If you already have a retirement account through your employer, check whether the plan offers index fund options.

2. Evaluate index fund options

Once you have an account, it’s time to choose your funds. Check out the index the fund tracks, its expense ratio and any minimum investment requirements. Many investors pay close attention to expense ratios because lower fees can allow you to invest more money over time. Also, make sure the fund aligns with your goals and timeline. You also may want to check whether the fund has a history of tracking error, which shows how closely it follows its index.

3. Purchase index fund shares

Once you’ve selected your fund, the process of buying shares is straightforward. Search for the fund by its name or ticker symbol in your brokerage account and place your order. Consider setting up recurring contributions so you can consistently put money toward your future. This approach is called dollar-cost averaging and often is used to help manage the effect of market ups and downs over time.

Index fund FAQs

How do you earn money from index funds?

You earn money from index funds in 2 main ways: price appreciation and dividends. As the value of the assets in the fund grows, so does your investment. Many index funds also pass through dividends earned from their holdings. That money can be automatically reinvested to help your investment grow faster over time.

Can you start investing in index funds with only $100?

Yes. Low-cost index funds can be purchased for the price of a single share, which could be under $100, depending on the fund. Many mutual fund index funds have low or no minimum investment requirements, making it easier than ever to get started investing.

What are capital gains, and how do they apply to index funds?

Capital gains are the profits you earn when you sell an investment for more money than you paid for it. In a taxable investing account, capital gains from index funds may be subject to taxes, depending on how long you held the investment and your tax situation.

Navy Federal can help support your investing goals

Index funds are one of the simplest ways to start building long-term wealth. Navy Federal has tools and resources that can support members who want help to get started or to plan their investments. Whether you’re opening your first brokerage account or building a diversified portfolio, we can help you find an investment strategy that fits your goals. 

Our MakingCents library of articles can help you learn more about investing. Navy Federal Investment Services offers IRA accounts, custodial accounts and access to knowledgeable financial advisors who can help you create a personalized wealth-building plan. If you prefer a hands-off approach, you can get started with Digital Investor, our online investment tool.