What an index fund is and why people buy them

An index fund is a collection of stocks or bonds that mirrors a specific market index — a list of companies or securities grouped by some rule. The S&P 500 index, for example, tracks 500 large U.S. companies. An S&P 500 index fund holds those same 500 stocks in the same proportions, so when you buy one share, you own a tiny piece of all 500 companies at once.

People invest in index funds because they spread risk across many companies instead of betting on one or two. You also pay lower fees than you would with a fund manager who picks stocks individually. The trade-off is that your returns match the market's average performance — you won't beat the market, but you won't fall as far behind it either.

Index funds exist for almost every market segment: U.S. stocks, international stocks, bonds, real estate, and combinations of all three. The fund you choose depends on what you want to own and how much risk you can tolerate.

Key Takeaways

  • You buy index funds through a brokerage account — a company that holds your money and executes trades — not directly from the fund company.
  • Opening a brokerage account takes 10 to 20 minutes online and requires a Social Security number, proof of address, and a bank account to fund it.
  • Index funds charge annual fees called expense ratios, usually between 0.03% and 0.20% per year, which come out of your returns automatically.
  • You can buy index funds inside a retirement account like a 401(k) or IRA, which offer tax advantages that make long-term investing cheaper.
  • The minimum investment varies by fund and brokerage, but many allow you to start with $1 to $100.

Opening a brokerage account

Before you can buy an index fund, you need a brokerage account — a financial account that holds your money and lets you buy and sell investments. You open this with a brokerage firm, not with the fund company itself. Common brokerages include Fidelity, Vanguard, Charles Schwab, E-Trade, and Robinhood, though dozens of others exist.

To open an account, you visit the brokerage's website, click "Open an Account," and answer questions about yourself: your name, address, Social Security number, employment status, and investment experience. The process takes 10 to 20 minutes. The brokerage will ask you to verify your identity, usually by uploading a photo of your driver's license or passport. Some brokerages also ask you to link a bank account so they can confirm your address.

Once your account is approved — usually within one business day — you can deposit money from your bank account into the brokerage. That money sits in a cash account until you use it to buy an index fund. You can deposit as little as $1 or as much as you want, though some brokerages have minimum deposit amounts for certain account types.

Choosing which index fund to buy

The index fund you choose depends on what market you want to own and what your investment timeline is. If you want broad U.S. stock market exposure, you might buy an S&P 500 fund or a total U.S. stock market fund. If you want international stocks, you might buy an emerging markets fund or a developed markets fund. If you want bonds, you might buy a bond index fund. Many people buy a mix of all three.

The same index can be offered by multiple fund companies. For example, Vanguard, Fidelity, and Schwab all offer S&P 500 index funds, but they have slightly different names and slightly different expense ratios. When you search for "S&P 500 index fund" on your brokerage's website, you will see several options. Compare the expense ratio — the annual fee, shown as a percentage — and pick the one with the lowest cost. The difference between 0.03% and 0.20% per year is small on a small account but compounds over decades.

If you are unsure which index to choose, a target-date fund is a simpler option. It automatically holds a mix of stocks and bonds, and it shifts toward more bonds as you approach retirement. You only need to pick the year you plan to retire, and the fund does the rest.

Placing your first trade

Once you have chosen your index fund and deposited money into your brokerage account, buying it is straightforward. Log into your account, search for the fund by its ticker symbol or name, and click "Buy." The brokerage will ask how many shares you want to purchase or how much money you want to spend. Enter that number, review the order, and confirm.

The trade executes immediately during market hours (9:30 a.m. to 4 p.m. Eastern time on weekdays). If you place an order after market hours or on a weekend, it will execute the next time the market opens. You will see the shares appear in your account within seconds, and the cash will leave your account at the same time.

After you buy, you own those shares until you sell them. You do not have to do anything else — the fund automatically reinvests dividends (payments companies make to shareholders) unless you tell it not to. Most investors leave their money alone and let it grow.

Understanding fees and expenses

Index funds charge an expense ratio, an annual fee that comes out of your returns automatically. You do not write a check for it — the fund company deducts it from the fund's value each day. A fund with a 0.10% expense ratio costs you $10 per year for every $10,000 you have invested.

Expense ratios for index funds typically range from 0.03% to 0.20% per year. Actively managed funds, where a manager picks stocks, often charge 0.50% to 1.50% or higher. Over 30 years, the difference between a 0.10% index fund and a 1.00% actively managed fund can mean tens of thousands of dollars in extra costs.

Some brokerages also charge trading commissions — a fee each time you buy or sell. Most major brokerages have eliminated commissions on stock and index fund trades, so you usually pay nothing to buy or sell. Always check your brokerage's fee schedule before you open an account.

Tax-advantaged accounts for index fund investing

You can buy index funds in a regular brokerage account, but you will pay taxes on any gains and dividends each year. A tax-advantaged retirement account lets you invest without paying taxes until you withdraw the money, which saves you thousands over time.

A 401(k) is a retirement account offered by your employer. You contribute money from your paycheck before taxes are taken out, and your employer may match part of your contribution. You can usually choose from a list of index funds to invest in. A traditional IRA (Individual Retirement Account) is an account you open on your own; contributions may be tax-deductible, and you do not pay taxes on gains until you withdraw. A Roth IRA is similar, but you contribute after-tax money and withdrawals are tax-free.

Contribution limits vary by account type and change each year. For 2024, you can contribute up to $7,000 to an IRA and up to $23,500 to a 401(k) if your employer offers one. If you have access to a 401(k) with an employer match, that is usually the best place to start, because the match is assistance programs.

What happens after you buy

After you buy an index fund, you own it until you sell it. The fund's value changes every day as the stocks or bonds inside it go up and down. You can check your account balance anytime by logging into your brokerage, but most investors do not check it every day — daily fluctuations are normal and do not mean anything has gone wrong.

If you want to add more money over time, you can set up automatic deposits from your bank account to your brokerage. Many investors do this monthly or with every paycheck. Buying the same fund repeatedly at different prices is called dollar-cost averaging, and it is a simple way to build wealth without trying to time the market.

If you need the money before retirement, you can sell your shares anytime the market is open. You will get whatever the shares are worth that day — they may be worth more or less than you paid. If you sell at a gain, you will owe taxes on the profit in a regular brokerage account. In a retirement account, you may face penalties if you withdraw before age 59½, depending on the account type.

Frequently Asked Questions

How much money do I need to start investing in index funds?

Most brokerages let you open an account with no minimum deposit, and many index funds allow you to buy a single share for $1 to $100. Some brokerages offer fractional shares, meaning you can invest any dollar amount, even if it does not add up to a whole share. Start with whatever amount feels comfortable.

Can I lose all my money investing in index funds?

An index fund's value can drop significantly during a market downturn, but it has never gone to zero. The S&P 500, for example, has recovered from every major crash in its history. If you need the money within five years, index funds may be too risky. If you can leave it alone for 10 years or more, history suggests you will come out ahead.

Should I buy individual stocks or index funds?

Index funds are simpler and cheaper for most people. You own hundreds of companies at once, so one bad stock does not hurt you much. Individual stocks require research and carry more risk. Most professional investors recommend index funds for people who do not want to spend time picking stocks.

What is the difference between a mutual fund and an ETF?

Both are collections of investments, but they trade differently. A mutual fund trades once per day after the market closes, at a price set by the fund company. An ETF (exchange-traded fund) trades throughout the day like a stock, and its price changes minute to minute. For index fund investing, both work fine. ETFs often have slightly lower expense ratios.

Do I have to reinvest dividends?

Most brokerages automatically reinvest dividends by default, meaning the cash gets used to buy more shares. This compounds your returns over time. You can turn this off if you want the cash instead, but reinvesting is usually the better choice for long-term investing.