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 grouped by some rule. The S&P 500 index, for example, tracks 500 large U.S. companies. An index fund that tracks the S&P 500 holds all 500 of those stocks in the same proportions, so when you buy one share of that fund, 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 by hand. The fund simply buys what the index says to buy and holds it, which costs less to run.

Index funds come in two main forms: mutual funds and exchange-traded funds (ETFs). Mutual funds are priced once per day after the market closes. ETFs trade throughout the day like individual stocks do. Both track an index, but they work differently in practice — that matters for how you buy them and what you pay.

Key Takeaways

  • You need a brokerage account with a company like Fidelity, Vanguard, or Charles Schwab to buy index funds; you cannot buy them directly from the company that runs the fund.
  • Index funds charge annual fees called expense ratios, which range from under 0.05% to over 0.5% depending on the fund; lower fees mean more of your money stays invested.
  • The S&P 500 index fund is the most common starting point because it covers a broad range of large U.S. companies and has been tracked by many funds for decades.
  • You can invest a lump sum or set up automatic monthly contributions; most brokerages let you start with as little as $1 to $500 depending on the fund.
  • Index funds are long-term holdings — people typically keep them for years or decades, not days or weeks, because short-term trading costs money and rarely beats the market.

Opening a brokerage account

Before you can buy an index fund, you need an account with a brokerage — a company licensed to buy and sell securities on your behalf. Major brokerages include Fidelity, Vanguard, Charles Schwab, E-Trade, and Robinhood. Each one offers index funds, though the specific funds available and the fees charged vary.

To open an account, you visit the brokerage's website, provide your name, address, Social Security number, and employment information, and link a bank account. The process takes 10 to 20 minutes. The brokerage will verify your identity and may ask for proof of address. Once approved — usually within one business day — you can deposit money and start buying.

You do not pay the brokerage a fee to open an account or hold money in it. You pay only when you buy or sell, and most brokerages charge zero commission on stock and ETF trades. Mutual funds sometimes have a small transaction fee, but many brokerages waive it for their own funds. Read the fee schedule before you open the account so you know what to expect.

Choosing which index fund to buy

The S&P 500 index fund is the most common choice for someone starting out. It tracks 500 large U.S. companies across many industries, so it spreads risk and reflects the overall health of the U.S. economy. Most major brokerages offer at least three S&P 500 index funds, each with a slightly different expense ratio.

Vanguard's S&P 500 ETF (ticker: VOO) charges 0.03% per year. Fidelity's S&P 500 index mutual fund (FXAIX) charges 0.015% per year. Schwab's S&P 500 ETF (SWPPX) charges 0.02% per year. The difference sounds tiny, but on $10,000 invested, you pay $3 per year with Vanguard, $1.50 with Fidelity, and $2 with Schwab. Over decades, those small differences compound.

Beyond the S&P 500, you can also buy index funds that track the total U.S. stock market (which includes mid-size and small companies), international stocks, bonds, or combinations of all three. A beginner often starts with one broad fund and adds others later as their portfolio grows. Do not buy multiple S&P 500 funds — that is redundant and wastes money on fees.

Understanding expense ratios and other costs

An expense ratio is the annual percentage fee the fund charges to cover management, administration, and trading costs. It is deducted from the fund's value automatically, so you do not write a check. A fund with a 0.03% expense ratio costs $3 per year on every $10,000 you own. A fund with 0.5% costs $50 per year on the same amount.

Index funds have lower expense ratios than actively managed funds because they simply track an index rather than paying a manager to pick stocks. The lowest-cost index funds charge between 0.01% and 0.05% per year. Anything above 0.2% is expensive for an index fund and worth avoiding if a cheaper option exists.

Some brokerages also charge a transaction fee when you buy a mutual fund — typically $49.95 per trade. ETFs do not have this fee at most brokerages. If you plan to buy once and hold for years, a single $49.95 fee is small. If you plan to add money monthly, ETFs are cheaper because you avoid the fee each time.

Making your first purchase

Once your account is open and funded, buying an index fund takes a few clicks. Log into your brokerage account, search for the fund by name or ticker symbol, and enter the number of shares you want to buy or the dollar amount you want to invest. For a mutual fund, you can buy fractional shares, so you can invest exactly $500 even if one share costs $150. For an ETF, you typically buy whole shares, so if one share costs $400 and you have $500, you buy one share and have $100 left over.

Place the order during market hours (9:30 a.m. to 4 p.m. Eastern time on weekdays). For a mutual fund, the order executes at the closing price that day. For an ETF, it executes immediately at the current market price. Either way, the fund appears in your account within one business day.

After your first purchase, you can set up automatic monthly contributions if you want. Most brokerages let you schedule a transfer from your bank account on a specific day each month, and the money automatically buys more shares of the fund you chose. This is called dollar-cost averaging — you invest the same amount regularly regardless of whether the price is high or low, which reduces the risk of buying everything at the worst time.

Tax accounts and where to hold index funds

You can hold an index fund in a regular taxable brokerage account, or in a tax-advantaged account like an IRA or 401(k). In a taxable account, you pay capital gains tax when you sell the fund at a profit, and you pay tax on any dividends the fund distributes. In an IRA or 401(k), you do not pay tax on gains or dividends while the money is in the account — you pay tax only when you withdraw it in retirement.

If your employer offers a 401(k) with a match, that is usually the best place to start because the match is assistance programs. If you do not have access to a 401(k), or you have already contributed the maximum, a Roth IRA is the next priority for most people. You can contribute up to $7,000 per year (as of 2024, though this amount changes). After you max out an IRA, a regular taxable brokerage account is the next step.

The index fund itself works the same way in any account — it tracks the same index and charges the same fee. The account type just determines how the tax works.

What to do after you buy

Once you own an index fund, the main task is to leave it alone. Index funds are designed to be held for years or decades. The price will rise and fall with the market — sometimes by 10% or 20% in a single year — but that is normal. Selling during a downturn locks in losses and means you miss the recovery. People who panic-sell during market drops almost always regret it.

Check your account balance once or twice a year, not every day. Daily checking encourages panic selling and does not change anything. If you set up automatic monthly contributions, the system will keep buying more shares regardless of the price, which is exactly what you want.

Over time, if you add other types of investments — bonds, international stocks, or individual company stocks — your index fund may become a smaller part of your overall portfolio. That is fine. Many people keep a core holding of a broad index fund and add other things around it.

Frequently Asked Questions

Can I lose all my money in an index fund?

Theoretically, yes, but only if the entire economy collapses and all 500 companies in the S&P 500 go to zero. That has never happened in U.S. history. More realistically, the market can drop 30% to 50% in a severe recession, which means your money shrinks temporarily — but it has always recovered within a few years. If you need the money within five years, an index fund is too risky.

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

ETFs trade throughout the day like stocks, so the price changes minute by minute. Mutual funds are priced once per day after the market closes. ETFs usually have no transaction fee at brokerages, while mutual funds sometimes charge $49.95 per trade. For a beginner, either works, but ETFs are slightly cheaper if you plan to add money monthly.

Do I have to reinvest the dividends?

Most brokerages automatically reinvest dividends by default, which means the cash is used to buy more shares of the fund. This is usually the best choice because it compounds your returns. You can change this setting to receive the cash instead, but reinvestment is simpler and more tax-efficient in retirement accounts.

How much money do I need to start?

Most brokerages let you start with $1 to $500, depending on the fund. Some mutual funds have a $1,000 or $3,000 minimum for the first purchase, but you can add smaller amounts later. ETFs have no minimum because you buy whole shares at whatever price they are trading for that day. Start with whatever you can afford — even $50 per month adds up over time.

Should I try to time the market or wait for a crash?

No. People who try to time the market — waiting for a crash to buy or selling before a drop — almost always do worse than people who simply invest regularly regardless of the price. If you have money now, invest it now. If you get paid monthly, invest monthly. The long-term trend of the market is up, and time in the market beats timing the market.