Investing in Index Funds: What You Need to Know (2024)

With a net worth of more than $96.5 billion, as of July 2022, Warren Buffett is one of the most successful investors of all time. His investing style, which is based on discipline, value, and patience, has yielded results that have consistently outperformed the market for decades. While regular investors—that is, the rest of us—don’t have the money to invest the way Buffett does, we can follow one of his ongoing recommendations: Low-cost index funds are the smartest investment most people can make.

As Buffettwrote in a 2016 letter to shareholders, “When trillions of dollars are managed by Wall Streeters charging high fees, it will usually be the managers who reap outsized profits, not the clients. Both large and small investors should stick with low-cost index funds.”

If you’re thinking about taking his advice, here’s what you need to know about investing in index funds.

Key Takeaways

  • Index funds are mutual funds or ETFs whose portfolio mirrors that of a designated index, aiming to match its performance.
  • Over the long term, index funds have generally outperformed other types of mutual funds.
  • Other benefits of index funds include low fees, tax advantages (they generate less taxable income), and low risk (since they’re highly diversified).

What Is an Index Fund?

An index fund is a type of mutual fund or exchange-traded fund (ETF) that holds all (or a representative sample) of the securities in a specific index, with the goal of matching the performance of that benchmark as closely as possible. The S&P 500 is perhaps the most well-known index, but there are indexes—and index funds—for nearly every market and investment strategy you can think of. You can buy index funds through your brokerage account or directly from an index-fund provider, such as Fidelity.

When you buy an index fund, you get a diversified selection of securities in one easy, low-cost investment. Some index funds provide exposure to thousands of securities in a single fund, which helps lower your overall risk through broad diversification. By investing in several index funds tracking different indexes you can built a portfolio that matches your desired asset allocation. For example, you might put 60% of your money in stock index funds and 40% in bond index funds.

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Index Fund: Pros

Index Fund: Cons

  • No downside protection

  • Doesn't take advantage of opportunities

  • Cannot trim under-performers

  • Lack of professional portfolio management

What Are the Benefits of Index Funds?

The most obvious advantage of index funds is that they have consistently beaten other types of funds in terms of total return.

One major reason is that they generally have much lower management fees than other funds because they are passively managed. Instead of having a manager actively trading, and a research team analyzing securities and making recommendations, the index fund’s portfolio just duplicates that of its designated index.

Index funds hold investments until the index itself changes (which doesn’t happen very often), so they also have lower transaction costs. Those lower costs can make a big difference in your returns, especially over the long haul.

“Huge institutional investors, viewed as a group, have long underperformed the unsophisticated index-fund investor who simply sits tight for decades,” wrote Buffett in his 2014 shareholder letter. “A major reason has been fees: Many institutions pay substantial sums to consultants who, in turn, recommend high-fee managers. And that is a fool’s game.”

What's more, by trading in and out of securities less frequently than actively managed fund do, index funds generate less taxable income that must be passed along to their shareholders.

Index funds have still another tax advantage. Because they buy new lots of securities in the index whenever investors put money into the fund, they may have hundreds or thousands of lots to choose from when selling a particular security. That means they can sell the lots with the lowest capital gains and, therefore, the lowest tax bite.

If you're shopping for index funds, be sure to compare their expense ratios. While index funds are usually cheaper than actively managed funds, some are cheaper than others.

What Are the Drawbacks of Index Funds?

No investment is ideal, and that includes index funds. One drawback lies in their very nature: A portfolio that rises with its index falls with its index. If you have a fund that tracks the S&P 500, for example, you’ll enjoy the heights when the market is doing well, but you’ll be completely vulnerable when the market drops. In contrast, with an actively managed fund, the fund manager might sense a market correction coming and adjust or even liquidate the portfolio’s positions to buffer it.

It’s easy to fuss about actively managed funds’ fees. But sometimes the expertise of a good investment manager can not only protect a portfolio, but even outperform the market. However, few managers have been able to do that consistently, year after year.

Also, diversification is a double-edged sword. It smooths out volatility and lessens risk, sure; but, as is so often the case, reducing the downside also limits the upside. The broad-based basket of stocks in an index fund may be dragged down by some underperformers, compared to a more cherry-picked portfolio in another fund.

The Bottom Line

Index funds have several attractive pros but also some cons to consider. The funds are passive investments that track major indexes making them a low-cost investment option. These funds are nearly as automatic and hands-off as using a robo-advisorwhich is another option for those looking for low-cost investing. Understanding what an index fund is and how it compares to other investments is the best first step you can take.

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  1. Bloomberg. "Billionaires Index."

  2. Berkshire Hathaway Inc. "To the Shareholders of Berkshire Hathaway Inc.," Page 24.

  3. Berkshire Hathaway Inc. "To The Shareholders of Berkshire Hathaway Inc.," Page 19.

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Investing in Index Funds: What You Need to Know (2024)

FAQs

Investing in Index Funds: What You Need to Know? ›

Index funds involve passive investing, using a long-term strategy without actively picking securities or timing the market. Index funds should match the risk and return of the market based on the theory that, in the long term, the market will outperform any single investment.

What do you need to know about index funds? ›

Index funds are investment funds that follow a benchmark index, such as the S&P 500 or the Nasdaq 100. When you put money in an index fund, that cash is then used to invest in all the companies that make up the particular index, which gives you a more diverse portfolio than if you were buying individual stocks.

Is index fund good for beginners? ›

Index funds are a good choice for people who are new to investing or prefer lower-risk options. They provide exposure to the stock market without too much risk.

What to check before investing in an index fund? ›

6 Things to Consider Before Investing in Index Funds
  1. Tracking error. The tracking error of an index fund measures how closely the fund's returns match the returns of the underlying index it tracks. ...
  2. Expense Ratio. ...
  3. Risk Tolerance. ...
  4. Investment Goals. ...
  5. Past Performance. ...
  6. Time.

Is it worth investing in index funds? ›

Index funds are popular with investors because they promise ownership of a wide variety of stocks, greater diversification and lower risk – usually all at a low cost. That's why many investors, especially beginners, find index funds to be superior investments to individual stocks.

What is the best index fund for beginners? ›

VFIAX and QQQM are often described as some of the best index funds for beginner investors.

How do you actually make money from index funds? ›

As with other mutual funds, when you buy shares in an index fund you're pooling your money with other investors. The pool of money is used to purchase a portfolio of assets that duplicates the performance of the target index. Dividends, interest and capital gains are paid out to investors regularly.

What are 2 cons to investing in index funds? ›

The benefits of index investing include low cost, requires little financial knowledge, convenience, and provides diversification. Disadvantages include the lack of downside protection, no choice in index composition, and it cannot beat the market (by definition).

How much of my income should I invest in index funds? ›

Some experts recommend at least 15% of your income. Setting clear investment goals can help you determine if you're investing the right amount.

What are the cons of investing in index funds? ›

Cons of Index Funds
  • Less Flexibility. While your portfolio is less affected by a declining singular asset, it's not immune to the fluctuations of the larger market, including economic downturns and bear markets. ...
  • Moderate Annual Returns. ...
  • Fewer Opportunities for Short-Term Growth.
Oct 9, 2023

What is the 4 rule for index funds? ›

The 4% rule says people should withdraw 4% of their retirement funds in the first year after retiring and take that dollar amount, adjusted for inflation, every year after. The rule seeks to establish a steady and safe income stream that will meet a retiree's current and future financial needs.

Do billionaires invest in index funds? ›

There are many ways to start investing, but one that's worked for billionaires like Warren Buffett is investing in low-cost index funds.

How long should you keep your money in an index fund? ›

Ideally, you should stay invested in equity index funds for the long run, i.e., at least 7 years. That is because investing in any equity instrument for the short-term is fraught with risks. And as we saw, the chances of getting positive returns improve when you give time to your investments.

Are index funds safe during a recession? ›

The important thing to remember about index funds is that they should be long-term holds. This means that a short-term recession should not affect your investments.

Why doesn't everyone just invest in the S&P 500? ›

That's because your investment gives you access to the broad stock market. Meanwhile, if you only invest in S&P 500 ETFs, you won't beat the broad market. Rather, you can expect your portfolio's performance to be in line with that of the broad market. But that's not necessarily a bad thing.

What is the average return on index funds? ›

The average stock market return is about 10% per year, as measured by the S&P 500 index, but that 10% average rate is reduced by inflation. Investors can expect to lose purchasing power of 2% to 3% every year due to inflation. » Learn more about purchasing power with NerdWallet's inflation calculator.

What are the pros and cons of index funds? ›

The benefits of index investing include low cost, requires little financial knowledge, convenience, and provides diversification. Disadvantages include the lack of downside protection, no choice in index composition, and it cannot beat the market (by definition).

Do you actually own stock in an index fund? ›

Investing in individual stock gives you partial ownership of a company. Index investing also gives you partial ownership in companies, but you'll have to look up the fund's portfolio to learn what you own (and in what proportion to your total ETF position).

Is the S&P 500 an index fund? ›

The S&P 500 is a stock market index composed of about 500 publicly traded companies. You cannot directly invest in the index itself. You can buy individual stocks of companies in the S&P 500, or buy an S&P 500 index fund or ETF.

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