In our article on how to invest in stocks, we talked about investing in individual stocks and also investing in index funds. Index funds are simply a fund that tracks a market index by investing in the individual components of that index. Index funds are managed by fund managers whose job is to make sure the index fund performs the same as the index itself.
Below we are going to share with you some simple steps for investing in index funds to help you with your investment process.
Understand the various index funds
While there are hundreds of index funds, we’d like to share a few index funds in terms of what they invest in and how you can diversify your exposure. Examples are:
- SPY which tracks the S&P 500
- QQQ which tracks the Nasdaq composite
- IWM which tracks the Russel 2000 index
- EEM which tracks emerging markets
- TLT which focuses on the 20+ year treasury bonds in the US
- FEZ which tracks the Euro Stoxx 50 Index
Now keep in mind, these are broadly focused index funds. If you believe certain sectors of the market will do well for years to come (perhaps semiconductors, or residential real estate), you can invest in index funds which track those sectors.
We recommend having a mix of exposure to US indexes, some overseas indexes, and a few sectors you think will be strong for years to come.
It’s important to look at the long-term charts of those indices you are interested in so you can see their price volatility. This will give you an idea of what kind of volatility you can expect by looking back in history (20+ years) to see what kinds of drawdowns to expect and how to manage your risk based on this.
We recommend looking at the weekly or monthly charts (i.e. each candle represents a week or month of price movement) to help you see the long term trends, drawdowns and volatility.
Choose funds based upon costs, limitations and tracking performance
There are often several different funds you can invest in for each index you want to track. Each index fund will have varying performance fees, slight variations in how accurately they track the index, and some may have limitations in terms of when you can buy and sell.
The key is to find the funds that:
- most accurately track the index
- have the lowest fees (management fees)
- have the least restrictions (if any) in terms of when you can buy and sell
Buy shares of the index fund through your brokerage account
Once you’ve selected the funds you want to invest in, make sure your brokerage account has those funds available to buy and sell shares from.
Once you’ve confirmed they do, it’s time to buy shares in each individual fund. We generally recommend buying several funds at a time so you can easily be diversified from the moment you start buying shares across many index funds.
Again, depending upon your investment goals will determine how much you should have in index funds vs individual stocks.
Why invest in index funds?
As we’ve mentioned in our prior article on how to invest in stocks, index funds have several benefits for investors, such as:
- Diversifying risk – since an index fund invests in dozens, if not hundreds of stocks, no one stock will make or break your returns, and should any one fall, you still have others to maintain strength for the fund.
- Less time – individual stocks take a bit more research to understand their nuances, potential challenges and future risks. Index funds are managed by fund managers whose main job is to perform consistently over time.
- Less expensive vs mutual funds – unlike actively managed mutual funds, index funds are less expensive in terms of management fees, thus you pay less over time to get exposure to index funds.
- Greater stability – unlike individual stocks which can lose a lot of value from something as simple as the CEO stepping down, index funds generally have lesser volatility to them and thus smaller drawdowns than many individual stocks may have.
Index funds to consider starting with
For those of you who are new to investing long term, here are a few funds to consider investing in long-term offering a range of stability, fixed income and some speculative risk.
- SPDR ETF TRUST (SPY) which tracks the S&P 500. Has averaged about a 10% return annually over the last 50 years
- Invesco QQQ Trust (Nasdaq: QQQ) which tracks the Nasdaq index, thus giving you exposure to some of the top tech companies in the world.
- PIMCO Income Strategy Fund II (NYSE: PFN) which is a strong dividend producing fund (8.44%) that invest in a wide variety of local and nationally represented stocks and entities.
- iShares MSCI Switzerland ETF (CBOE: EWL) which gives you exposure to one of the more stable economies in the world and their major corporate holdings.
Using index funds to build your wealth
For those learning to invest in the stock market and build your investment portfolio, index funds give you access to a wide range of stocks and risk profiles while simplifying the process. For those of you wanting to grow your wealth over time without having much time to do the research, you should consider index funds for providing one solution to your financial and investing goals.