Index Funds Explained for Complete Beginners
If you have spent any time reading about investing in the United States, you have almost certainly come across the term index fund. It gets mentioned constantly by personal finance writers, recommended by some of the most successful investors in American history including Warren Buffett, and championed by financial advisors as the single best starting point for everyday Americans who want to build wealth without needing a finance degree or spending hours analyzing stocks. And yet despite all of that coverage, a surprising number of Americans have only a vague sense of what an index fund actually is, how it works, and why it has become the dominant investment vehicle for ordinary American investors over the past few decades.
This article explains index funds completely from the ground up, covering what they are, how they work, why they outperform most alternatives over the long run, what the different types look like, how to buy one, and what to watch out for so that by the end you have everything you need to make an informed decision about whether index funds belong in your own investment strategy.
What an Index Is and Why It Matters
Before you can understand an index fund you need to understand what an index is, because an index fund is simply a fund that tracks one.
A stock market index is a list of companies selected according to specific criteria, used to represent the performance of a particular segment of the stock market. The most famous index in the United States is the S&P 500, which tracks 500 of the largest publicly traded American companies selected by a committee based on factors including market size, liquidity, and financial viability. When you hear on the news that the S&P 500 went up 1.2 percent today, that means the collective value of those 500 companies increased by 1.2 percent on average.
Other widely followed indexes in the US include the Dow Jones Industrial Average, which tracks 30 large American companies, the Nasdaq Composite, which tracks thousands of companies listed on the Nasdaq exchange with a heavy weighting toward technology companies, and the Russell 2000, which tracks 2,000 smaller American companies. There are also international indexes like the MSCI World Index and the MSCI Emerging Markets Index that track companies in countries outside the United States.
Each index has its own methodology for which companies it includes and how it weights them, but the core purpose of every index is the same: to provide a measurable representation of how a specific slice of the market is performing.
What an Index Fund Actually Is
An index fund is an investment fund, either a mutual fund or an exchange-traded fund, that is designed to replicate the performance of a specific index by holding the same securities in the same proportions as that index. A fund tracking the S&P 500 holds shares in all 500 companies in the S&P 500, weighted proportionally so that larger companies like Apple and Microsoft represent a larger share of the fund than smaller companies. When those 500 companies collectively go up in value, the fund goes up in value. When they go down, the fund goes down.
The defining characteristic of an index fund is that it is passively managed. There is no team of analysts researching stocks and deciding which ones to buy or sell based on predictions about future performance. The fund simply holds what the index holds and adjusts only when the index itself changes, which happens periodically as companies are added to or removed from the index. This passive approach is what makes index funds so different from actively managed funds, and it is at the heart of why they tend to outperform most alternatives over long periods.
Why Index Funds Outperform Most Actively Managed Funds
This is the question at the center of one of the most consequential debates in American investing, and the evidence accumulated over decades is remarkably consistent. The vast majority of actively managed funds, meaning funds where professional managers make deliberate decisions about which stocks to buy and sell in an attempt to beat the market, fail to outperform their benchmark index over periods of ten years or more after accounting for fees.
Study after study, including the S&P SPIVA report published annually, consistently shows that somewhere between 80 and 90 percent of actively managed US stock funds underperform the S&P 500 index over 15-year periods. This is not because professional fund managers are incompetent. It is because markets are extraordinarily efficient, meaning information about companies is so widely available and so rapidly incorporated into stock prices that consistently identifying undervalued stocks before everyone else does is essentially impossible to do reliably over long periods.
When you add the fees that actively managed funds charge, typically 0.5 to 1.5 percent of assets annually or higher, the performance gap widens further. Every dollar paid in fees is a dollar that does not compound and grow in the investor’s account. Over 30 years, the difference between paying 0.03 percent annually in fees on an index fund and paying 1 percent annually on an actively managed fund compounds into a genuinely significant difference in final account value, sometimes tens of thousands of dollars on a modest investment.
Warren Buffett, widely considered the greatest investor in American history, has repeatedly and publicly stated that most Americans, including after his death the trustee of his own estate, should put the majority of their money in a low-cost S&P 500 index fund. When the person who arguably knows the most about stock picking recommends index funds for ordinary investors, that recommendation carries significant weight.
The Different Types of Index Funds
Not all index funds track the same index, and understanding the main categories helps you make a more informed decision about which ones belong in your portfolio.
Total US stock market index funds track the entire US stock market, including large companies, medium-sized companies, and small companies across every sector of the American economy. Fidelity’s FZROX, Vanguard’s VTSAX, and Schwab’s SWTSX are among the most widely held total market index funds in the United States. These funds give you the broadest possible exposure to American economic growth in a single investment.
S&P 500 index funds track specifically the 500 largest US companies and are the most widely recognized category of index fund in America. Because the 500 largest companies represent such a dominant share of total US market value, the performance of S&P 500 funds and total market funds is very similar over most time periods. Fidelity’s FXAIX, Vanguard’s VOO, and iShares IVV are among the most popular S&P 500 index funds available to American investors.
International index funds track companies outside the United States, giving American investors exposure to economic growth in Europe, Japan, China, India, and other markets around the world. Adding an international index fund to a US-focused portfolio reduces the risk of being entirely dependent on the American economy and provides exposure to faster-growing economies in emerging markets. Vanguard’s VXUS and Fidelity’s FZILX are widely used international index funds among American investors.
Bond index funds track indexes made up of bonds rather than stocks, providing exposure to fixed-income investments that tend to be less volatile than stocks and provide a cushion during stock market downturns. For younger investors with long time horizons, bond index funds typically represent a smaller portion of the portfolio that grows as the investor approaches retirement and needs more stability.
Sector index funds track specific sectors of the economy, such as technology, healthcare, real estate, or energy, rather than the broad market. These are more specialized and more volatile than broad market funds and are generally better suited to investors who have already built a diversified core portfolio and want targeted exposure to a specific industry.
Target date index funds combine stocks and bonds in a single fund with an allocation appropriate for someone planning to retire in a specific year, automatically becoming more conservative as that year approaches. These are the simplest possible investment for someone who wants to contribute money and never have to make another allocation decision.
Index Funds vs ETFs — What Is the Difference
This distinction confuses many beginning investors because the terms are sometimes used interchangeably and sometimes used as if they are completely different things.
An ETF, which stands for exchange-traded fund, is a type of investment fund structure. A mutual fund is another type of investment fund structure. Both can be either actively managed or passively managed to track an index.
An index fund is a description of investment strategy, meaning a fund that passively tracks an index. That strategy can be implemented through either a mutual fund structure or an ETF structure.
So when someone says index funds, they might mean index mutual funds, index ETFs, or both. The Vanguard S&P 500 ETF with the ticker symbol VOO is an index fund implemented as an ETF. The Fidelity 500 Index Fund with the ticker symbol FXAIX is an index fund implemented as a mutual fund. Both track the S&P 500 index passively.
For most beginning investors the practical differences between index ETFs and index mutual funds are minor. ETFs trade throughout the day on stock exchanges like individual stocks, while mutual funds are priced and traded once per day after the market closes. ETFs can be bought in fractional shares at most major brokerages, making them accessible with any dollar amount. Some mutual funds have minimum initial investment requirements, though Fidelity eliminated minimums on their index mutual funds and Vanguard has reduced theirs significantly.
For a beginner investing through a Roth IRA or brokerage account at Fidelity, Schwab, or Vanguard, either structure works well and the choice between them matters far less than simply choosing a low-cost fund that tracks a broad market index and starting to invest.
What Expense Ratios Are and Why They Matter So Much
The expense ratio is the annual fee charged by a fund, expressed as a percentage of your assets in that fund. It is deducted automatically from the fund’s returns rather than billed separately, which makes it easy to overlook but no less real in its impact on your long-term returns.
Index funds are famous for having extremely low expense ratios because the passive management approach requires so little human labor compared to actively managed funds. The Fidelity Zero Total Market Index Fund charges an expense ratio of 0%, meaning it costs investors nothing in annual fees. Vanguard’s total market index funds charge around 0.03 to 0.04 percent annually. Schwab’s index funds are similarly priced.
To understand why even a small difference in expense ratio matters over long periods, consider an investment of $10,000 growing at 7 percent annually over 30 years. With a 0.03 percent expense ratio, your account grows to approximately $75,800. With a 1 percent expense ratio, the same investment at the same gross return grows to only approximately $57,400. The extra 0.97 percent in annual fees costs you more than $18,000 over 30 years on a single $10,000 investment. On a larger portfolio built over decades, the difference compounds into hundreds of thousands of dollars.
Always check the expense ratio before investing in any fund. For index funds, anything above 0.20 percent is higher than necessary given how many excellent low-cost options exist. The best index funds charge between 0 and 0.05 percent annually.
How to Actually Buy an Index Fund
The process of buying an index fund is straightforward once you have an investment account open, and for most Americans the right account to open first is a Roth IRA at a major US brokerage.
Fidelity, Vanguard, and Charles Schwab are the three most widely recommended brokerages for beginning index fund investors in the United States. All three offer commission-free trading, extremely low-cost index funds, no account minimums on most accounts, and strong customer service. Opening an account at any of them is a fully online process that takes about fifteen minutes and requires your Social Security number, a government-issued ID, and your bank account information for the initial funding transfer.
Once your account is open and funded, buying an index fund is as simple as searching for the fund by name or ticker symbol, entering the dollar amount you want to invest, and confirming the purchase. At Fidelity and Schwab you can invest any dollar amount including fractional shares, so you are not limited to purchasing in whole share increments.
After your initial purchase, setting up automatic recurring investments, often called automatic contributions or automatic investing depending on the platform, is the most important next step. Automating your contributions means you invest consistently every month regardless of what the market is doing, which removes emotion from the process and takes advantage of a strategy called dollar cost averaging, where you automatically buy more shares when prices are low and fewer shares when prices are high.
Dollar Cost Averaging and Why It Works for Index Fund Investors
Dollar cost averaging is the practice of investing a fixed dollar amount at regular intervals regardless of market conditions. It is the natural result of setting up automatic monthly contributions to your index fund, and it is one of the most effective risk management strategies available to ordinary American investors.
When markets are down and share prices are lower, your fixed monthly contribution buys more shares. When markets are up and share prices are higher, the same contribution buys fewer shares. Over time this averaging effect means you never invest your entire portfolio at a market peak, which is the scenario most new investors fear most.
The alternative, trying to time the market by waiting for the perfect moment to invest, consistently produces worse results than simply investing regularly regardless of market conditions. Decades of data on American investor behavior show that the average investor significantly underperforms the market because they buy after prices have already risen and sell after prices have already fallen, driven by emotion rather than discipline. Automatic regular contributions to a low-cost index fund removes that emotional decision-making entirely and replaces it with a consistent mechanical process that works in your favor over time.
What Happens When the Market Goes Down
This is the question that causes the most anxiety for new index fund investors, and addressing it honestly is important because every investor will experience market downturns at some point, often severe ones.
The US stock market has experienced numerous crashes, corrections, and bear markets throughout its history, including the dot-com crash of 2000 to 2002, the financial crisis of 2008 to 2009, and the rapid crash and recovery of early 2020. In every single one of these events, the market eventually recovered and went on to reach new highs. An investor who held their index funds through every one of these downturns without selling came out significantly ahead of an investor who sold during the panic and waited to buy back in.
When the market goes down, your index fund balance goes down with it. This is uncomfortable but not a loss unless you sell. The underlying companies you own through the fund continue operating, earning revenue, and generating value. A temporary decline in the market price of their shares does not change the fundamental reality of what those businesses are doing. For a long-term investor with a time horizon of ten, twenty, or thirty years, a market downturn is not a disaster. It is a sale on shares that will eventually be worth more than they are today.
The investors who get hurt by market downturns are those who panic and sell at the bottom, locking in losses, and then wait too long to buy back in, missing the recovery. The investors who benefit from downturns are those who keep contributing their regular monthly amounts, buying more shares at lower prices, and then holding through the recovery to see the value of those additional shares grow.
Frequently Asked Questions
- Can you lose all your money in an index fund?
Losing your entire investment in a broad market index fund would require every company in the index to go bankrupt simultaneously, which has never happened in US market history and would represent a collapse of the entire American economy. While index fund values can decline significantly during market downturns, a total loss is essentially impossible for a diversified broad market fund. Individual stocks can go to zero. A fund holding hundreds or thousands of companies cannot.
- How much money do you need to start investing in index funds?
At Fidelity and Schwab you can start with any dollar amount including as little as one dollar, since both platforms offer fractional share investing with no minimum account balance. Vanguard has historically had higher minimums on some mutual funds but their ETF versions can be purchased in fractional shares at many brokerages with no minimum.
- Should you put all your money in one index fund?
A single total US stock market index fund provides broad diversification across American companies of all sizes and sectors, which is genuinely sufficient for many investors, particularly beginners. Adding an international index fund provides exposure to global markets and reduces dependence on the US economy alone. Most financial advisors consider a simple two-fund portfolio of a US total market fund and an international fund to be a complete and well-diversified long-term investment strategy.
- How are index funds taxed in the USA?
In a Roth IRA, index fund gains grow completely tax-free and withdrawals in retirement are not taxed. In a traditional IRA or 401k, gains grow tax-deferred and withdrawals in retirement are taxed as ordinary income. In a taxable brokerage account, dividends are taxed in the year received and capital gains are taxed when you sell, with long-term gains on investments held more than one year taxed at lower rates than short-term gains on investments held less than one year.