What are index funds and how do you start investing?

As a new homeowner, this past year has been a financial roller coaster. From unexpected repairs to buying new furniture, I’ve spent the last year depleting my savings and paying off debt. But now that my credit cards are all paid off, it is time to start focusing on building wealth which means learning how to trade and invest. Assuming that you have already taken advantage of tax advantaged accounts (401 (k), Roth IRA, Health Saving Accounts etc), low-cost index funds is one of the most efficient ways to grow your money as a newbie investor. Warren Buffet even recommends investing in index funds as a long-term investment strategy. Vanguard’s Total US Stock Market Index Fund (VTSAX) and the S&P 500 Index Fund come highly recommended by the F.I.R.E. (Financial Independence and Retire Early) community.

 

What are index funds?

An index fund is a type of mutual fund which pools money from a group of investors.

An index fund mirrors market indexes like the Dow Jones and the S&P 500. The S&P 500 gauges how the U.S. economy is doing by tracking 500 of the largest companies in the country. If you buy an index fund that tracks the S&P 500, you’re essentially buying a small piece of these 500 companies.

 

Related: Investment Terms For Beginners

 

Why invest in index funds?

With an index fund you can invest in the entire U.S. market, certain industries like technology, international stocks and bonds.

Since index funds are generally made up of a diverse group of stocks or bonds, they are less risky than individual stocks. So instead of buying a Google stock (which some may consider a risky investment), an index fund provides broad market exposure by reducing the overall risk of your investment portfolio.

Also since index funds are passively managed, their management fees are a lot less. As a rule of thumb, invest in broad-market, low fee index funds to see more return.

The most well-known low-cost brokerage firms include Vanguard, Schwab and Fidelity.

 

Why are index funds beneficial?

  1. Easy investment strategy for beginners
  2. Low operating expenses (or expense ratios)
  3. Provides broad market exposure – diversification
  4. Less transactions – buying and selling
  5. Long term asset appreciation/growth

 

Types of Index Funds

(Based on Market Cap)

When investing in index funds, one of the first things to consider is market capitalization – how big will the companies in your portfolio be? Market cap size matters because it determines risk and ultimately your return.

 

Large Cap Market Index Funds

Large cap index funds include companies valued at over $10 billion. These companies are very stable and typically offer steady returns.

 

Mid Cap Market Index Funds

Mid-cap market index funds include companies worth between $2-$10 billion. These companies are riskier than large cap companies but offer investors more growth opportunities.

 

Small Cap Market Index Funds

Lastly, small cap funds include companies with a market cap of less than $2 billion. These companies are usually volatile meaning that there’s lots of opportunity for growth but this also means that investors are likely to take on a lot more risk.

If you can tolerate a lot of risk in your investment portfolio this is a solid choice because small cap market index funds typically outperform large cap index funds (except for when there is a recession).

 

Index Fund Market Cap Summary

  1. Large cap: $10-$100 billion
  2. Mid cap: $2-$10 billion
  3. Small cap: Less than $2 billion

 

Knowing your risk tolerance, would you invest in large, mid or small-cap funds?

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