Investing in stocks is the best way to build long-term wealth.
Assuming 10% average returns (the long-term average of the S&P 500 index), a single $1,000 investment could grow into:
- $10,834 after 25 years
- $72,890 after 45 years
- $490,370 after 65 years
No investment experience or clever stock picks are necessary to achieve these kinds of returns.
All it takes is investing in index funds.
But what are index funds, exactly? Here’s everything investors need to know about index funds and index ETFs.
What is a stock market index?
An index fund is an investment product that is designed to track the performance of a given stock market index. Index funds are a way to invest in dozens or hundreds of companies all at once.
To understand how index funds work, we first need to understand what a stock market index is.
A stock market index is a dataset that tracks the performance of a group of stocks. Indexes are used by investors to gauge the performance and day-to-day movements of the stock market as a whole.
If someone mentions that “the stock market is up 1% today”, they are likely referring to a stock market index.
The S&P 500, for example, is an index of 500 of the largest publicly traded companies in America. The index includes many household names, like Amazon, Microsoft, Starbucks and more.
Each stock is priced individually, and the stock price will change based on the market and how well the company performs. Traditionally, investors would look at the stock price movements of individual companies — but indexes now provide a simpler approach to gauge the overall market.
How do stock market indexes work?
Stock market indexes are a selection of companies that are chosen for inclusion by the index manager.
Companies may be chosen based on factors such as:
- The size of the company (market capitalization, or market cap)
- The geographic region of the company (U.S., U.K., global, etc.)
- The industry of the company (technology, healthcare, etc.)
- Other factors (profitability, liquidity, etc.)
Once selected for inclusion in the index, the company’s share price will be included in calculating the price and performance of the index.
An index looks at the combined change in price for all stocks included in that index. This provides a birds-eye-view of what the overall market is doing on any given day.
Index fund weighting
Index funds are “weighted” using different formulas. Weighting refers to how the index price is calculated, and how much weight is given to each company in the index.
Stocks aren’t necessarily given an equal weighting in the index. If there are 100 stocks in an index, that does not necessarily mean that each stock makes up 1% of the index.
Many index funds are market-cap weighted. This means that bigger companies may have more impact on the movements of the overall index, compared to smaller companies.
For example, the S&P 500 includes 500 companies, but Apple alone makes up approximately 7% of the index’s value. Meanwhile, some of the smaller companies in the S&P 500 may make up just 0.1% or less of the index.
If Apple stock were to suddenly decrease by 50%, but all other stock prices were unchanged, the S&P 500 index would drop by approximately 3.5% (50% of Apple’s 7% share of the index). But if a small S&P 500 stock were to drop 50%, the S&P 500 index would barely budge.
These are the primary weighting formulas to be aware of:
- Market-cap weighted: Companies are weighted by market capitalization (total value of the entire company, based on the current share price). The higher the market cap, the more heavily the stock is represented in the index. The S&P 500 is an example of a market-cap weighted index.
- Equal weighted: Companies are weighted equally. If there are 100 companies in an equal-weighted index, each company will represent 1% of the index. If there are 500 companies, each will represent 0.2% of the index.
- Price-weighted: Companies are weighted by share price. The higher the share price, the more heavily the stock is represented in the index. This method uses the price of a single share, not the value of the company as a whole. The DJIA is an example of a price-weighted index.
There are many different indexes, but here are some of the most common.
Popular stock market indexes
S&P 500: An index of the 500 largest companies in America. The Standard and Poor’s 500 (S&P 500) is widely regarded as the best representation of the overall US market. The S&P 500 is weighed by market capitalization and is the most popular large cap index in the US.
Dow Jones Industrial Average (DJIA): An index of 30 large U.S. companies that are among the most actively traded on the US stock market. The DJIA is weighted by share price.
Russell 2000: An index of 2000 of the smallest publicly traded companies in the US. The Russell 2000 is market-cap weighted.
Nasdaq 100: An index of 100 of the largest and most actively traded companies on the Nasdaq stock exchange. It’s a technology-focused index and is weighted based on market cap.
FTSE 100: An index of 100 of the largest companies on the London Stock Exchange. It is weighted based on market cap.
Bond index funds: Most index funds are for stocks, but there are also some bond index funds, like the S&P U.S. Aggregate Bond Index.
In addition to these, each major country has its own index — the DAX in Germany, the NIKKEI 225 in Japan, etc. Each serves as a benchmark for that country’s stock market.
There are also international indexes that combine the performance of stocks in many different countries. Broad international funds focus primarily on established economies, while emerging markets funds focus on developing economies.
What is a stock market index fund?
An index fund is an investment product that allows everyday investors to buy into all the companies included in the underlying index.
Index funds are designed to match the performance of that particular index. If the S&P 500 gains 9% in a year, S&P 500 funds will also gain around 9% (maybe slightly less, due to management fees and/or tracking errors).
While the index is merely a dataset, the index fund is an actual investment product that you can buy in a brokerage account.
How do index funds work?
Most index funds trade as ETFs, or mutual funds. These are funds that bundle money from many investors into one fund, and then buy many different stocks (AKA securities).
ETFs trade like stocks — you could buy $50 of an S&P 500 index fund, or sell $1,000 of a Nasdaq 100 index fund — instantly during market hours.
Mutual funds trade a bit differently. You can place an order at any time, but it won’t be filled until the close of the current trading day (or the following trading day, depending on order time).
For example, you could buy an S&P 500 index fund like Vanguard’s VOO. Vanguard (the fund manager) buys all the stocks that are included in the S&P 500, and bundles them together in VOO. When you buy VOO, you’re buying one ETF — but you now own very small slices of all the 500 companies included in the S&P 500 index.
Index funds are passively managed
This means that the fund manager doesn’t actively buy or sell stocks in an effort to make short-term profits.
Managers buy the stocks that are included in the index, and will buy more as the fund grows, and sell any companies that are removed from the index. But they won’t actively trade or try to time the market.
This is beneficial for two reasons:
- It results in lower fees (some low-cost index ETFs have fees of 0.07% or less)
- It results in lower turnover of assets (which can be beneficial for capital gains tax purposes)
Index funds work similarly across the board, but there are two main vehicles that these funds can come in.
Index fund exchange traded funds (ETFs)
Exchange traded funds, commonly called “ETFs”, are the most popular form that index funds take. ETFs:
- Trade like stocks
- Have a ticker symbol (like “VOO” for Vanguard’s S&P 500 index)
- Can be bought or sold instantly during market trading hours
- Have prices that change constantly throughout the day
Index fund mutual funds
Index funds can also be structured as mutual funds. Mutual funds:
- Trade only at the end of the trading day (orders can be placed at any time, but don’t execute until after normal trading hours)
- Have a ticker symbol
- Have prices that change only once per day
- May have higher fees than ETFs
Benefits of index funds
Index funds are a very popular investment — in fact, there’s now more money in passive index funds than there is in actively managed funds.
Why are investors increasingly pouring money into index funds? Here are the primary benefits.
Index funds are generally a low-cost investment. Most funds have a small fee, called the expense ratio, to manage the fund. But this fee is generally pretty insignificant — often 0.1% or less. For perspective, that’s just $10 per year on a $10,000 investment.
Meanwhile, many actively managed mutual funds charge 1% or more. That’s $100 per year on that same $10,000 investment. Ongoing fees can have a huge negative impact on your investment returns over time, so it’s important to minimize them.
Diversification helps reduce risk by spreading out your bets. Instead of owning a single company, you can own hundreds.
Index funds make it simple to add instant diversification to your portfolio. With a couple clicks, you can buy an S&P 500 index fund and gain exposure to 500 large-cap American companies.
The alternative would be to manually buy shares in all 500 of these companies — which would take ages, and could also cost a lot if your broker charges transaction fees.
Index funds are a passive (non-active) investment strategy. Investors who prefer a hands-off approach can simply buy into an index fund, and their returns will closely follow the returns of the overall market. No active effort required!
In other words, you don’t need to be an investing expert to start investing in index funds. It’s a very simple approach to start investing.
Drawbacks of index funds
Of course, index funds are not perfect. Here are the main downsides to be aware of.
When you invest in index funds, you’re trusting in “the stock market” as a whole. You’re essentially along for the ride, whatever that ride might entail.
This isn’t necessarily a bad thing. But for investors who prefer to steer their own investment decisions, choosing individual investments may be preferable to index fund investing.
Limited to one type of stock
Many index funds are limited to a certain type of stock. For instance, the S&P 500 and the DJIA both track large-cap stocks. These are very large companies, all of which are based in the US. The Russell 2000, meanwhile, tracks small-cap companies only.
There are some broader total stock market index funds that track thousands of small, medium, and large-cap companies. But the majority of index funds focus on a single segment of the market.
You’ll never beat the market
Index funds are a way to match the performance of the stock market, or a segment of it. This approach can produce decent, consistent returns — but you’re never going to beat the market using index funds.
“Beating” the market (earning higher returns than the overall stock market) is difficult to do, but it’s impossible using solely index funds. To earn higher returns than the market, you’ll generally need to invest in individual stocks, or trade actively.
How to invest in stock index funds
Index funds are simple to invest in. Here’s a three-step process to follow.
1. Choose an index
First, select which index you’d like to follow. For US-based stocks, the S&P 500 is a great place to start. You can get some other ideas in the popular stock market indexes section above, or by browsing the fund company websites.
2. Choose an index fund
Once you have the index, you can select the index fund. Because each buys the same companies, the factors you’re really looking for are low fees, the fund’s performance after fees, and the fund structure (ETF or mutual fund). Find some ideas below.
Where to buy index funds
Vanguard Total Stock Market Index Fund (VTI) - a total US stock market index fund (ETF) with an expense ratio of just 0.03%.
Vanguard Total International Stock Market Index Fund (VXUS) - an international (global) index fund (ETF) with an expense ratio of 0.07%.
Vanguard 500 Index Fund (VOO) - an S&P 500 index fund (ETF) with an expense ratio of 0.03%.
Vanguard Total Bond Market (BND) - a US total bond market index fund (ETF) with an expense ratio of 0.035%.
Note: The Vanguard index funds above are also available as mutual funds.
Fidelity ZERO Total Market Index Fund (FZROX) - a US total stock market index fund (mutual fund) with no expense ratio (0.00%).
Fidelity ZERO International Index Fund (FZILX) - an international (global) stock market index fund (mutual fund) with no expense ratio (0.00%).
Other low-cost ETF managers include Schwab, Blackrock, and iShares.
3. Buy index fund shares through your broker
If you do have an account:
- Transfer money into your brokerage account
- Take the ticker abbreviation from the fund you selected (like VOO or FZILX) and type it into your stock broker’s platform
- Select “Buy” and enter the amount you wish to purchase
- For mutual funds, enter in a dollar amount
- For ETFs, you may need to enter in a number of shares instead. If an ETF is trading at $50 per share, you’d enter 10 shares to invest $500 worth (most brokers now also allow you to purchase a certain dollar amount, i.e. $500, regardless of the price of one share of the ETF)
- Use the “market” price option (this just means that you’re buying at the current market price)
- Place the order
If the market is currently open and you buy an ETF, your order will complete immediately. Congratulations, you now own an index fund!
If the market is closed, your order will be completed when the market opens on the following business day.
If you place an order for a mutual fund, your order will be completed at the close of the market, or the market close on the following business day.
Are index funds a good investment?
Index funds are a great option for passive investing. If you don’t want to actively research stocks, do your due diligence, or actively monitor your investments, then index funds are the best approach.
Over the long term, S&P 500 index funds returned around 10% per year. It’s impossible to know whether that past performance will be matched in the future, but the same could be said of any investment strategy.
Index funds are powerful for building wealth over the long term. They closely track market performance, which tends to grow substantially over long periods of time.
But the best index funds can do is match the market — they will never produce outsized returns.
If you want the potential to earn very high returns (and are comfortable with more risk), investing in individual stocks is worthwhile.
Deciding what to invest in should involve considering your investment goals, your risk tolerance, your desired activity level, and your investment timeline.
Index funds as a core holding
Index funds make for an excellent “core holding” in a diversified portfolio.
This means that it may be beneficial to have the bulk of your investments in passive, low-cost index funds.
You can then allocate smaller portions to individual stocks, or to alternative asset classes like real estate, bonds, or cryptocurrency.
For example, an investor might construct a portfolio consisting of:
- 50% U.S. Total Stock Market index funds (like VTI)
- 20% International Total Market index funds (like VXUS)
- 15% U.S. Total Bond Market index funds (like BND)
- 15% individual stocks
In this case, the bulk of the investor’s asset allocation is in diversified index funds — but they can still allocate 15% of their portfolio to their own stock selections.
Index funds vs. individual stocks
There’s no clear right or wrong here. It depends on your investment objectives, experience level, and preferences.
- Index funds are a moderate risk, moderate reward investment
- Individual stocks are a higher risk, higher (potential) reward investment
For example, Tesla stock (TSLA) had a 5-year return of around 1,500% (at the time of this writing). Amazon (AMZN) returned around 244%.
Meanwhile, S&P 500 index funds had a 5-year return of around 79% during the same time period.
On the other hand, there are plenty of individual stocks with awful 5-year returns. Boeing (BA) had a 5-year return of -1%, while Lumen (LUMN) had a 5-year return of -55%.
Investors in Tesla and Amazon did quite well. But investors in Boeing and Lumen would have been much better off buying a S&P 500 index fund.
So which is better — individual stocks or index funds?
Individual stocks can have higher returns, if you select the right stocks.
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How many index funds should I own?
In some cases, a single index fund is sufficient. A total market index fund, for example, covers thousands of companies. Some investors may wish to invest in several funds: a US stock fund, an international stock fund, and a bond fund, for example.
What are the best index funds?
In recent years, broad US stock market funds like the S&P 500 have performed very strongly. But the best index funds change from year to year, based on performance. Look for funds with low fees and diversified holdings.
How much to invest in index funds?
It’s wise to invest any money that you don’t need in the next 5+ years. If you have your expenses covered, and you have an emergency fund built, you can invest as much as you are comfortable with Go Deeper →
What is the difference between index funds and mutual funds?
Many mutual funds are actively managed, which means investment managers buy and sell assets to earn returns. Index funds are passively managed, meaning they are set up to track the performance of the underlying index. Mutual funds also tend to have higher fees than index funds.
What are low cost index funds?
Low cost refers to funds with low management fees. Each fund will charge an expense ratio, which is an annual fee that goes towards running the fund. Many low-cost index funds are available with expense ratios of 0.1% or less (that’s $10 per year on a $10,000 investment).
How much do index funds return?
The long-term return of the S&P 500 has been right around 10% per year. You can look up historical returns for various indexes. Note that past performance does not dictate future performance. All investing comes with risk.
What are broad based index funds?
Broad-based index funds are funds that track broad indexes, such as the S&P 500 or the Wilshire 5000 index.
How do index funds make money?
Index funds charge an annual fee, known as an expense ratio. This fee is automatically subtracted from a fund’s performance. For example, Vanguard’s S&P 500 ETF (VOO) charges a 0.03% expense ratio. If you have $10,000 invested in VOO, Vanguard will earn $3 per year from you.
How are index funds taxed?
Index funds are subject to capital gains tax, which applies whenever an investor sells an index fund. Dividends and distributions from these funds may also be subject to personal income tax or capital gains tax. Holding index funds in tax-advantaged retirement accounts can help ease the tax burden. Speak to a tax professional for details.
When to buy index funds?
It’s wise to buy index funds frequently. Making regular investments over a long period of time is a powerful way to build wealth.
How many index funds are there?
There are over 1,700 index funds, according to Kiplinger. However, keep in mind that many track the same underlying index. There are dozens of S&P 500 index funds, for example.
How often do index funds compound?
Index funds may distribute dividends and/or capital gains several times per year. This amount may be added back to the fund’s value, creating a compounding effect.