Index Funds for Beginners
An index fund is a fund that follows a market index. It buys the same stocks or bonds that are in the index, in about the same shares. It does not try to pick winners. It tries to match the market.
The best known index is the S&P 500. It holds about 500 leading US companies. A fund that tracks it holds those companies. A total stock market index fund holds the whole US stock market, in one fund.
A short history
Vanguard launched the first index fund for individual investors in 1976. John Bogle led that work. The idea was simple. Most fund managers did not beat the market after fees, so a low cost fund that matched the market would serve most savers well.
That idea has held up. Index funds now hold a large share of US fund assets. They are the base for many retirement plans.
Why index funds work for many people
- Low cost. An index fund is run by rules, not by a team that trades often. That keeps the fee low.
- Broad reach. One fund can hold hundreds or thousands of stocks. A single stock can fall hard. A broad fund spreads that risk.
- Steady results. Most active funds do worse than their index after fees, over long periods.
The S&P Dow Jones Indices SPIVA scorecard tests this each year. Over the 15 years ending December 31, 2024, 88 percent of large-cap US funds did worse than the S&P 500. For mid-cap funds, 95 percent did worse than the S&P MidCap 400. For small-cap funds, 92 percent did worse than the S&P SmallCap 600.
What it costs
The yearly fee is called the expense ratio. It is a percent of the money in the fund. A broad low-cost index fund often charges 0.03 percent to 0.10 percent a year. As an example, the Vanguard Total Stock Market Index Fund Admiral Shares charges 0.04 percent a year.
On 10,000 dollars, a fee of 0.03 percent is 3 dollars a year. A fee of 1 percent is 100 dollars a year. On 100,000 dollars, a fee of 1 percent is 1,000 dollars a year. A fee of 0.03 percent is 30 dollars a year.
Worked example: what a 1 percent fee costs over 30 years
These are round, made up numbers. They show the math. They are not a forecast for any fund.
Start with 100,000 dollars. Add nothing else. Assume a steady return of 7 percent a year before fees. Over long periods, US stocks have returned about 10 percent a year before inflation and about 7 percent after inflation. This example uses 7 percent, as a round hypothetical.
- Step 1. With no fee, the money grows at 7 percent a year. After 30 years, 100,000 dollars becomes about 761,200 dollars.
- Step 2. With a fee of 0.03 percent, the money grows at 6.97 percent a year. After 30 years, it becomes about 754,800 dollars.
- Step 3. With a fee of 1 percent, the money grows at 6 percent a year. After 30 years, it becomes about 574,300 dollars.
- Step 4. Compare the two funds. The fund with the 0.03 percent fee ends with about 180,500 dollars more than the fund with the 1 percent fee. That is 754,800 dollars minus 574,300 dollars.
The fee looks small in year one. It is 30 dollars against 1,000 dollars. Over 30 years, the gap grows, because the extra fees would have earned growth too. The 0.03 percent fund ends about 6,400 dollars below the no fee result. The 1 percent fund ends about 180,500 dollars below the low fee fund.
Use this calculator to see how a small fee difference can change an end balance over time.
Why the fee matters more than picking the best fund
Two index funds that track the same index hold nearly the same stocks. Their returns before fees are nearly the same. The fee is the main thing that sets them apart. A fund that charges 1 percent must beat a fund that charges 0.03 percent by 0.97 percent a year, every year, just to tie. Few funds do that for 30 years.
Picking the best fund is hard, because last year winners often fade. Checking the fee is easy, and it stays with you each year. Start with the fee. Then check that the fund tracks a broad index. Then check that it fits your plan.
A simple example portfolio
You can build a whole portfolio from one to three index funds. Here is a simple example, for illustration only, not a recommendation for anyone in particular.
| Fund | What it holds | Example share |
|---|---|---|
| Total US stock index fund | The whole US stock market | 60 percent |
| Total international stock index fund | Stock markets outside the US | 30 percent |
| Total bond index fund | US bonds | 10 percent |
On 10,000 dollars, that is 6,000 dollars in US stocks, 3,000 dollars in international stocks, and 1,000 dollars in bonds. A younger saver who can handle bigger ups and downs often holds more in stocks and less in bonds. An older saver often holds more in bonds.
How to buy an index fund
- Open a low-cost brokerage account, or use a retirement account such as a 401(k) or Roth IRA.
- Pick one broad index fund. Check its expense ratio first.
- Buy it. Many mutual funds have minimums of 1,000 dollars to 3,000 dollars. An exchange traded fund starts at the price of one share, and some brokers let you buy part of a share.
- Keep adding on a set schedule, and leave the money alone.
What can go wrong
An index fund can fall. In 2008, the S&P 500 fell about 37 percent. A broad fund still falls when the whole market falls. It does not protect you in a crash.
Fees and taxes also cut into returns. A fund in a taxable account can pass on taxable gains. A fund in a retirement account does not face that tax each year. Check the tax rules for your account before you buy.
Mistakes to avoid
- Paying a high fee for a fund that tracks the same index as a low fee fund.
- Chasing last year’s best fund, then selling it after a bad year.
- Checking the balance each day, and trading on news.
- Putting all of your money in one stock or one sector, and calling it diversified.
This post is general education, not personal financial advice. Your own taxes, accounts, and retirement rules depend on your situation, so check the details that apply to you before you act on them.
To see the accounts mentioned in this post, visit the Tools and Accounts page, which lists plain links to each one.
Sources
- S&P Dow Jones Indices. SPIVA U.S. Year-End 2024 Scorecard. spglobal.com/spdji/en/spiva/article/spiva-us/
- Vanguard. Vanguard Total Stock Market Index Fund Admiral Shares (VTSAX), expense ratio 0.04 percent. investor.vanguard.com/investment-products/mutual-funds/profile/vtsax
- U.S. Securities and Exchange Commission. Mutual Funds and ETFs, a guide for investors. sec.gov/investor/pubs/sec-guide-to-mutual-funds.pdf
- S&P Dow Jones Indices. S&P 500 index. spglobal.com/spdji/en/indices/equity/sp-500/
