Saving money is extremely important, but what do you do after that? Due to inflation and low interest rates, money in your bank account actually loses value over time. In order to increase the value of your money over time, it needs to be invested. There are many strategies out there, but the most popular method for beginner investors is to buy index funds.
What is the Stock Market?
Before you can begin to understand index funds, you need to understand the stock market. And before you can understand the stock market, you need to understand stocks.
A stock–or share–is a piece of a company. Shares are created when a privately owned company decides to “go public.” This is usually done through an IPO (Initial Public Offering). During this process, the private company splits its ownership into millions of shares–or stocks.
These stocks are then bought and sold between millions of different buyers and sellers. This collection of buyers and sellers is known as the stock market. The stock market determines the price of a particular stock based on the buying and selling activity. More buyers = higher price. More sellers = lower price.
The stock market is much simpler than it is made out to be. While it may seem like investing in the stock market is reserved for the wealthy, investing in stocks is actually available to anyone with access to a computer or smart phone. With apps like Robinhood and the widespread elimination of trading commissions, anyone with an internet connection and a few extra bucks can invest in the stock market.
What are Index Funds?
An index fund is an ETF–or Exchange Traded Fund. An ETF is a basket of stocks that trades separately from the stocks themselves. For example, if you want to invest in the airlines industry as a whole, you could buy stocks for all of the airline companies, or you could invest in the U.S. Global Jets ETF (JETS).
ETFs allow you to own a large and diverse group of assets without owning all of the components, and there are tons of them. It’s estimated that there are over 5,000 ETFs trading globally, and these ETFs can be made to include anything: airlines, Bitcoin, the price of gold, even obesity trends (not kidding).
By far the most popular ETFs are the ones that track market indexes. These are known as index funds. Your popular market indexes include the Dow Jones Industrial Average (Dow Jones), the Standard & Poors 500 (S&P 500), and the top 100 NASDAQ stocks. These indexes are generally used to gauge the overall health and return of the stock market.
Since the stock market makes 8% per year on average, investing in an index fund should theoretically provide the same return. Investing in index funds also allows you to diversify your portfolio while minimizing the effort put in to manage it. For example, if you want to invest in the same companies as the S&P 500, you could buy all 500 stocks in the correct proportions, or you could buy an index fund like the SPDR S&P 500 ETF Trust (SPY).
How to Buy Index Funds
Now that you dipped your toes into the waters of index funds, it’s time to jump in.
Don’t know where to start? Follow these steps:
- Determine which account you need
- Decide on a brokerage firm
- Open your account
- Choose your index funds
- Buy an index fund… and then buy some more
1. Determine which account you need
Assuming you already have an emergency fund, the first step to creating a great financial future is to open an IRA or brokerage account.
An IRA (Individual Retirement Account) is a popular starting point. The money you make in an IRA is completely tax deductible–meaning Uncle Sam has to keep his grubby little fingers to himself. Well, kinda. You still have to pay income taxes on the contributions (or on the distributions, depending on your IRA type), but you get to skip out on the capital gains tax.
These accounts are great, but they have a couple drawbacks: (1) if you want to pull your money out of your IRA before you turn 60, you have to pay a 10% penalty fee, and (2) there is a limit on the amount you can contribute per year.
Your next option is a taxable brokerage account. These accounts allow you to move money in and out as much as you like, but all of the gains are taxable.
Do your research, and choose which account is best for you.
2. Decide on a brokerage firm
After you know which type of account you’d like to open, it’s time to pick which brokerage firm. The term “brokerage firm” may sound fancy, but it really means the company that manages your account. These are all companies you know–examples include Charles Schwab, eTrade, Fidelity, Vanguard, Robinhood, etc.
Which brokerage firm you choose depends on your personal preference. I use Charles Schwab due to the stability of the company, and I have used Robinhood in the past. Many traders I know use Interactive Brokers, and many friends of mine use eTrade.
Choose which company is best for you. No matter which one you choose, they will all have index funds available for you.
3. Open your account
Once you’ve picked a brokerage firm, you need to open your account. Each company is different, but most–if not all–will require some personal info to get going. This includes your:
- Mailing address
- Date of birth
- Social security number
- Beneficiary information
Go to your brokerage’s website and follow the steps to open your account. Once it is open, fund your account to complete your set up.
4. Choose your index funds
Phew! The hard part is done. Now the fun begins. After you open and fund your account, you’re ready to buy index funds. But which ones should you buy?
The most popular index fund is the SPDR S&P 500 ETF Trust (SPY). This particular index fund is available to all brokerage firms. Invesco QQQ Trust Series 1 (QQQ) and SPDR Dow Jones Industrial Average ETF Trust (DIA) are widely available as well.
Some brokerages may have index funds that are available to users of that brokerage only. Don’t worry, you will have plenty of options no matter what brokerage you choose. Do your research to find the best option for you.
When choosing an index fund, be sure to consider the expense ratio. This number represents the fee subtracted from your return. The higher the expense ratio, the higher the cost. Investment and account minimum’s may also come into play, so keep that in mind.
5. Buy an index fund… and then buy some more
You’re on the homestretch now. Your account is open and funded, and you know what index fund you want to buy. Now, the really fun part: buying! Click on the index fund you want, and decide how much you want to buy.
After this, you will likely be given a few choices to buy these index funds: market, limit, stop, and stop limit. Each of these order options has its purpose. When buying an index fund, a market order is sufficient.
When your order goes through, you are officially a stockholder! Exciting, isn’t it?
And I bet you’re thinking, “Wow, that was a lot. So after I buy into an index fund, I’m done, right?”
After you start investing in index funds, the focus shifts back to saving money. Then once you have some money saved up, put that money to work and invest it in more index funds. It’s the constant repetition and unceasing contributions that create real wealth. By contributing more, you are able to compound more in the long run.
For the novice investor, a good strategy is to buy index funds. Essentially, you get to hire someone to manage your money, and the fee you pay is usually well under 1%. Warren Buffett even says that buying index funds is the best option for most people. That sounds like a pretty good deal to me.