You can safely invest in index funds through mutual fund companies or as an index ETF directly through your broker. Investing in an index fund ETF is the most cost-effective, liquid, and efficient way to invest in an index.
As a 20-year veteran investor and certified financial markets analyst with 80% of my stock portfolio in index funds, I can help you make the decisions to maximize your long-term index investing profits.
Index funds have become the most popular investment tool in today’s stock market, yet few people understand what index funds are and how they work. All investors need to understand index funds because of their enormous influence. Index fund investing is easy, but there are some decisions you will need to make to help you avoid hazards, such as taxes and losses.
Should I invest in index funds?
Yes, you should invest in index funds to accumulate wealth over the long term. Index funds provide reduced risk through diversification, provide inflation-beating returns, and allow you to profit from the stock price growth and dividends of all the companies in an index.
How to start investing in index funds?
Before investing in index funds, you need to understand what they are and how they work. The first step in investing in index funds is understanding that stock market indexes go up over the long term. There are recessions and crashes, but upwards is the default direction.
How to Invest in Index Funds
The easiest way to invest in an index fund is to purchase an index-tracking ETF through an online broker. Alternatively, you can ask your financial advisor to recommend and purchase an index ETF or an index mutual fund on your behalf.
Factors to consider before investing in an index fund are choosing either an ETF or mutual fund, taxation, retirement fund, and avoiding stock market crashes. We discuss all of these in this article.
12 Tips For Investing in Index Funds
1. Where to buy index funds
Choosing a trustworthy broker with a large selection of commission-free ETFs is the first step before investing in index funds, as it will save you a lot of money. Many brokers offer free stock trades, but the selection of commission-free ETFs is important. Before choosing a broker, review their selection of ETFs and no-load mutual funds.
ETF Fund Fees: Firstrade vs. TDA vs. E-Trade
|# Commission-Free ETFs||2200+||300+||93||200+|
|Number of ETF providers||100||8||2||13|
Table 1: Commission-free ETF Comparison
Index funds usually play a role in any well-balanced portfolio. I have an account with Firstrade where all “loaded” and “no-load” funds are commission-free. With over 2,200 funds to choose from, the selection will meet most people’s needs.
Commissions: Firstrade vs. TDA vs. E-Trade
|Commissions & Fees||Firstrade||TD Ameritrade||E*Trade|
|Online Stock Orders||$0||$0||$0|
|Online Option Orders||$0||$0 + $0.65/Contract||$0 + $0.65/Contract|
|Online Mutual Fund Trades||$0||$49.99||$49.99|
|Minimum Initial Deposit||$0||$0||$500|
Table 2: Firstrade Commissions vs. Competitors
You can see that Firstrade has a substantial focus on having the best commissions in the industry. Even though T.D. Ameritrade, E-Trade & Schwab have now been forced to join the $0 Zero commissions bandwagon; Firstrade still offers the best value across stocks, options, and mutual funds.
2. How many index funds should I own?
You can own as many index funds as you wish. You will not get penalized for owning more index funds and diversifying your investment portfolio with commission-free brokers. Owning three to five index funds should provide enough diversification to a portfolio to reduce risk and ensure long-term profitability.
3. How much to invest in index funds
You should never invest more money in the stock market or an index fund than you can afford to lose. You must ensure you have enough capital to cover your living expenses for at least one year in case of redundancy or family emergencies.
When you have adequate investment capital, modern portfolio theory and financial advisors suggest you invest your age in percent in fixed income such as bonds or treasuries, and the rest in stocks, index funds, or real estate.
|Age||% invested in cash fixed income||% invested in stocks, index funds, or real-estate|
Table 3. Portfolio Allocation – Bonds vs. Stocks
4. Investing in index funds – taxes
How the government taxes a fund can determine how much money you can make. Choosing the wrong taxation method can lead to a high tax bill and conflicts with the IRS. Current tax law gives you three options for index fund investing, Traditional IRAs, Roth IRAs, and taxed investments.
A traditional individual retirement account (IRA) is tax-deferred. You do not pay taxes until you take money out of the account. The advantage of a traditional IRA is that the IRS will not tax funds in it, thus reducing your taxable income.
The disadvantage of a traditional IRA is that money is taxable when you withdraw it. Traditional IRAs can be a poor deal for younger and lower-income persons because early withdrawals could increase your income tax bill.
Traditional IRAs can also have tax implications for retirees. The Internal Revenue Service (IRS) taxes traditional IRA withdrawals at the owner’s current tax rate after retirement. Drawbacks to traditional IRAs include strict contribution limits ($6,000 for people under 50 and $7,000 for people over 50 in 2021). The IRA contribution limit can change, so you must check it. The IRS can penalize you for contributing too much money to an IRA.
Current law requires minimum distributions (payouts) from traditional IRAs after age 72. An IRA could increase a person’s taxable income by making payments they do not need. Traditional IRAs are popular because they are easy to set up. Many people get traditional IRAs through their employers.
Roth IRAs offer more tax advantages than traditional IRAs at a price. Holders pay no taxes on money they withdraw from a Roth IRA. Roth IRA holders, instead, make nondeductible contributions. The Roth IRA holder pays the taxes now to avoid future taxes. A Roth IRA can increase your tax bill.
A Roth IRA can be a good deal for a person who makes a high income while working and can afford taxes. The holder can avoid paying taxes when retiring and living on a limited income.
Roth IRAs are confusing because they resemble traditional IRAs. There are $6,000 a year Roth IRA contribution limits for people under 50 and $7,000 a year Roth IRA contribution limits for people over 50.
High-income individuals cannot contribute to Roth IRAs. The IRS banned singles making over $161,000 a year and married couples making over $208,000 a year from contributing to Roth IRAs in 2021.
Taxable Index Fund Accounts
Many people find buying index funds through a taxable account easier and cheaper than IRA investing. Paying taxes is often cheaper than paying the tax penalties associated with IRAs. Younger people and individuals who think they will need to take money out early need to avoid IRAs. A person under 50 could lose money from an IRA if he has to withdraw money because of emergencies.
Many people pay high taxes because circumstances, such as job loss, force them to make IRA withdrawals. Buying index funds outside an IRA can be a better tax strategy for persons with unstable incomes, such as the self-employed.
One advantage to taxable accounts is that a person can invest over $6,000 per year in them. You can invest unlimited amounts of money in taxable index accounts. A second advantage is selling taxable index funds for extra cash. Parking extra cash and savings in an index fund can be a smart strategy because index fund return on investment (ROI) exceeds inflation.
A final advantage to taxable accounts is purchasing small index funds to augment your savings. Taxable index funds are a good savings strategy because of their higher returns.
5. Consider index fund diversification or concentration.
Index funds offer broad diversification, a good strategy for people who want to limit risk. Diversified portfolios retain value by holding many stocks and limiting exposure to specific industries or sectors. A tech, retail, banking, or manufacturing downturn will not limit an S&P 500 index fund’s value because it holds stocks in all those sectors.
Diversification can limit returns because different sectors grow at different rates.
Concentrating your index fund’s scope can be more profitable. Investing in a Nasdaq 100 index ETF means exposure to the 100 largest non-financial stocks on the Nasdaq exchange. Apple, Microsoft, Alphabet, and Amazon are worth over $1 trillion, and all beat the S&P 500 by 15-35% last year.
Concentration leads to higher returns and higher risks.
6. How long to hold your index fund?
Investing in index funds should be the heart of your long-term investing strategy. Major US and European indexes rise over time, averaging 7-10% per year, combine growth with compounding, and you will be successful.
If you plan to hold index ETFs for a short duration, a concentration strategy makes sense; choosing a hot sector or industry can deliver a higher rate of return. An index fund diversification strategy is best for long-term investors because it limits risks. A long-term investor can afford a diversified portfolio’s lower return on investment.
7. Consider ESG funds
ESG is a set of standards for ethical investing that rates environmental, social, and good governance companies. If you want to make a positive impact on society, then you could consider ethical investing. ESG investing can also be very profitable, as it is becoming more popular and is a hot investment area.
Here is a list of ESG index funds that have outperformed the S&P 500 from 20202 to 2022.
|Ticker||Company||2-Year Return vs. S&P 500||Net Assets ($M USD)||Expense Ratio|
|PARWX||Parnassus Endeavor Investor||10.50%||$5,105||0.94%|
|ESGV||Vanguard ESG U.S. Stock ETF||6.20%||$5,903||0.12%|
|VFTAX||Vanguard FTSE Social Index Admiral||4.20%||$16,053||0.14%|
|DSI||iShares MSCI KLD 400 Social ETF||4.00%||$3,965||0.25%|
|ESGU||iShares ESG Aware MSCI USA ETF||2.90%||$25,165||0.15%|
|USSG||Xtrackers MSCI USA ESG Leaders Equity ETF||2.70%||$4,211||0.10%|
|FITLX||Fidelity U.S. Sustainability Index||2.50%||$2,002||0.11%|
|SUSL||iShares ESG MSCI USA Leaders ETF||2.50%||$4,202||0.10%|
|SPYX||SPDR S&P 500 Fossil Fuel Reserves Free ETF||0.50%||$1,320||0.20%|
Table 4: ESG Index Fund Performance 2020 to 2022
There are also index funds designed to make an impact by channeling money into specific areas. The NASDAQ OMX Clean Edge Smart Grid Infrastructure Index promotes green energy by investing in smart grid companies. The First Trust NASDAQ Clean Edge Smart Grid Infrastructure Index Fund (Ticker: GRID) is an ETF that invests in the NASDAQ OMX Clean Smart Grid Index.
8. Choose an ETF or a Mutual Fund
When deciding on an Index Fund, you need to consider the type of fund, a mutual fund or an exchange-traded fund. Exchange-traded funds are growing wildly in popularity due to their low tax structure, liquidity, and low costs.
|ETFs vs. Mutual Funds||ETFs||Mutual Fund|
|Fees||0% – 0-6%||1% – 3%|
|Traded Like Stocks on Exchanges||✔||X|
|Can be traded:||Intraday||End of day|
Table 5: ETFs vs. Mutual Funds Comparison
Mutual funds are generally actively managed by teams dedicated to beating the market, but only 17% succeed in their goal.
Passively managed ETFs track a specific stock market index to equal the market returns; this beats 82.5% of mutual funds in the long term. Passively managed index-tracking ETFs usually incur lower management fees than actively managed mutual funds. A fee saving of 2% per year compounded for 20 years could mean an extra 48% extra in your investment.
ETFs are exchange-traded funds purchased on the open market during trading hours and typically reflect the stock index price. ETFs can also be shorted and allow options trades.
The Facts About Actively Managed Mutual Funds
According to the Standard & Poor’s annual SPIVA report, over the last 10-years, 82.51% of actively managed mutual funds underperformed the benchmark. With mutual funds, you have the disadvantages of end-of-year capital gains taxes, you pay up to 3% in management fees, and you have only a 17% chance to attain the performance of a passively managed index ETF.
“Oblivious of the toll taken by costs, mutual fund investors willingly pay heavy sales loads and incur excessive fund fees and expenses, and are unknowingly subjected to the substantial but hidden transaction costs incurred by funds as a result of their hyperactive portfolio turnover.” John C. Bogle – Creator of the first Index investment Trust
For most investors, passive index-tracking ETFs are by far the best choice for lower taxes, lower fees, and stable performance.
9. Consider index fund costs.
Many indexed mutual funds come with higher costs, an initial large cash investment, and require investors to commit to an automatic monthly investment. Mutual fund costs include sales loads or charges, redemption fees, exchange fees, account fees, management fees, distribution fees, and other expenses.
Federal law requires mutual funds to list all the fees in the prospectus under the heading shareholder fees. You can find the prospectus on the fund manager’s website.
You must study the fee table carefully because some of these costs can add up. Some funds charge a 5% sales load for purchases. That means a person who purchases $1,000 worth of the fund will only own $950 worth of the fund. Funds can also charge a back-end sales load, which means the fund could charge a 5% fee on a sale of $1,000. Hence, the fund owner will receive $950 instead of $1,000.
There are no-load mutual funds. However, many no-load funds charge other exchange or exemption fees.
ETFs can be cheaper than mutual funds because they are often commission-free. Many ETFs charge account service fees and broker-assisted trading fees. You can avoid broker-assisted trading fees by trading yourself and account service fees by signing up for the electronic delivery of documents at the broker’s website.
You can determine the cost of ETFs by checking the fee section of the brokerage’s website.
10. Monitor performance & harvest tax losses
You will need to monitor your index funds’ performance. There is no reason to check index funds every day. The advantage of index funds is that they follow long-term strategies that require no supervision. The disadvantage is that many people do not see problems with their funds until it is too late. However, checking a fund’s performance monthly or bi-monthly is an excellent idea.
There are several effective means of tracking index fund performance. Most funds’ websites offer online tools for performance tracking. There are also robo advisors and apps that can track funds’ performance. I track my Index & ETF investments using Stock Rover, which I consider the best stock & ETF portfolio management, research, and screening software on the market today. Monitoring your funds’ performance is a necessary chore if you want to protect your money.
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Tax-loss harvesting is an attempt to reduce a tax bill by selling assets. Tax-loss harvesting is an effort to convert long-term capital gains into short-term gains. The IRS taxes long-term capital gains at a lower rate than short-term capital gains. The IRS considers short-term capital gains regular income higher than the capital gains rates of 0%, 15%, or 20% for most taxpayers. The IRS considers stocks, mutual funds, and ETF income long-term capital gains if they are held for more than one year.
A tax-loss harvester tries to avoid capital gains tax by selling losing equities to offset the taxes on the winning equities. The most common use of tax-farming is to avoid taxes on dividends. Capital gains taxes do not apply to unsold stocks, but they affect dividends.
11. Avoid stock market crashes.
Whether you actively invest in the stock market or passively invest through mutual funds, or exchange-traded funds, you need to reduce any losses you incur over the years of your investment.
Avoiding or minimizing the impact of major stock market crashes is at the heart of the MOSES System. The Moses strategy has three core indicators; you can use the best approach to eliminate most losses and compound your investments to beat the market.
MOSES will help you be alerted before the next crash happens, or at least before the significant down move begins. MOSES will also show you when the bear market is over.
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12. Use Dollar Cost Averaging
If you have not managed to avoid the stock market crash, your best alternative is to buy more index funds during the crash. Known as dollar-cost averaging, this popular strategy allows you to bring down your average cost per share during a crash, enabling you to maximize your profits as the market begins recovering.
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- How to Invest in Index Funds to Maximize Long-term Profits
- ETFs vs. Mutual Funds vs. Index Funds: Simply Explained
- Investing in Index Funds: Everything You Need to Know
- ETFs vs. Stocks. 7 Reasons ETFs Are Better