Standard & Poor’s 500 index funds are one of the most popular investments today, and it’s little wonder why. The S&P 500 index on which these funds are based has returned an average of about 10 percent annually over time, and represents hundreds of America’s best companies. With an S&P 500 index fund you get to own the market, instead of trying to beat it.
In fact, legendary investor Warren Buffett has long advised investors to buy and hold an S&P 500 index fund. So if you’re considering one for your portfolio, here’s what you’ll need to know to get started.
Index funds explained
An index fund is a type of investment fund – either a mutual fund or an ETF – that is based on an index. An index is a preset collection of stocks, and an index fund merely mimics the stocks in the index, rather than trying to pick which stocks will do well. So an index fund is a classic type of passively managed investment, and only adjusts its holdings when the underlying index changes.
An index fund is typically created around a specific theme. For example, there can be indexes for companies based on their location (such as the U.S.), their size (large companies, as in the S&P 500), their industry (such as semiconductors or healthcare), or whether they pay dividends. An index might also consist of only bonds, or only bonds of a certain quality and duration.
What is the S&P 500?
While there can be almost any number of indexes, the most famous ones are those based on the Dow Jones Industrial Average, the Standard & Poor’s 500 and the Nasdaq 100.
Of these, the S&P 500 Index has come to be seen as the bellwether for the American stock market. It contains about 500 of the largest companies in the United States, and when investors talk about “beating the market,” the S&P 500 is considered the standard.
In contrast, the Dow Industrials contains just 30 companies, while the Nasdaq 100 contains about 100 companies. While the holdings of these indexes do overlap somewhat, the S&P 500 contains the widest variety of companies across industries and is broadly diversified.
Why do investors like S&P 500 index funds?
S&P 500 index funds have become incredibly popular with investors, and the reasons are simple:
- Own many companies: These funds allow you to own a share in hundreds of stocks, even if you own just one share of the index fund.
- Diversification: This broad collection of companies means you lower your risk through diversification. The poor performance of one company won’t hurt you much.
- Low cost: Index funds tend to be low cost (low expense ratios) because they’re passively managed, rather than actively managed.
- Solid performance: Your returns will effectively equal the performance of the S&P 500, which has historically been about 10 percent annually on average over long periods.
- Easy to buy: It’s much simpler to invest in index funds than it is to buy individual stocks, because it requires little time and no investing expertise.
These are the biggest reasons that investors have turned to the S&P 500 in droves.
How to buy an S&P 500 index fund
It’s surprisingly easy to buy an S&P 500 fund, and you can usually set up your account to buy the index fund on auto-pilot, so you’ll almost never have to look at the account.
1. Find your S&P 500 index fund
It’s actually easy to find an S&P 500 index fund, even if you’re just starting to invest.
Part of the beauty of index funds is that an index fund will have exactly the same stocks and weightings as another fund based on the same index. In that sense, it would be like walking into five McDonald’s restaurants serving exactly the same food: which one would you choose? You’d probably select the restaurant with the lowest price, and it’s the same with index funds.
Here are two key criteria for selecting your fund:
- Expense ratio: To determine whether a fund is cheap, you’ll want to look at its expense ratio. That’s the cost that the fund manager will charge you over the course of the year to own the fund.
- Sales load: If you’re investing in mutual funds, you’ll also want to see if the fund manager charges you a sales load, which is a fancy name for a sales commission. You’ll want to avoid this kind of expense entirely. ETFs don’t charge a sales load.
S&P 500 index funds have some of the lowest expense ratios on the market. Index investing is already cheaper than almost any other kind of investing, even if you don’t select the cheapest fund. Many S&P 500 index funds charge less than 0.10 percent annually. In other words, at that rate you’ll pay $10 annually for every $10,000 you have invested in the fund.
Some funds go even cheaper than that. Here are five of the best S&P 500 index funds, including one that’s completely free. In investing, paying more doesn’t always guarantee better returns.
Again, since these funds are largely the same, your choice is not a “make or break” decision – you can expect to get the performance of the index, whatever that is, minus the expense ratio or any fees you’re paying. So costs are an important consideration here.
Select your fund and note its ticker symbol, an alphabetical code of three to five letters.
2. Go to your investing account or open a new one
After you’ve selected your index fund, you’ll want to access your investing account, whether it’s a 401(k), an IRA or a regular taxable brokerage account. These accounts give you the ability to purchase mutual funds or ETFs, and you may even be able to buy stocks and bonds later, if you choose to do so.
If you don’t have an account, you’ll need to open one, which you can do in 15 minutes or less. You’ll want one that matches the kind of investments you’re going to make. If you’re buying a mutual fund, then try to find a broker that allows you to trade your mutual fund without a transaction fee. If you’re buying an ETF, look for a broker that offers it without a commission, which is most of them now.
The best brokers offer thousands of ETFs and mutual funds without a trading fee. Here is Bankrate’s list of best brokers for beginners.
3. Determine how much you can afford to invest
You don’t have to be wealthy to begin investing, but you do have to have a plan. And that plan begins with figuring out how much you’re able to invest. You’ll want to add money regularly to the account, and should plan to hold it there for at least three to five years to allow the market enough time to climb and ride out any downturns.
The less you’re able to invest, the more important it is to find a broker that offers you low costs, because that’s money that could otherwise go into your investments.
Once you’ve figured out how much you can invest, move that money to your brokerage account. Then set up your account to regularly move a desired amount each week or month from your bank. Or you can set up your 401(k) account to move money from each paycheck.
4. Buy the index fund
Once you know the S&P index fund you want to buy and how much you’re able to invest, go to your broker’s website and set up the trade.
Stick to the broker’s easy trade entry form, which often appears right at the bottom of the screen. Input the fund’s ticker symbol and how many shares you’d like to buy, based on how much money you’ve put into the account.
If you’re able to move money into the brokerage account regularly, many brokers allow you to set up a trading schedule to buy an index fund on a recurring basis. This is a great option for investors who don’t want to remember to place a regular trade. You can set it and forget it.
As a result, you’ll be able to take advantage of the benefits of dollar-cost averaging, which can help you reduce risk and increase your returns.
Buying an S&P 500 index fund can be a smart decision for your portfolio, and that’s one reason that Warren Buffett has recommended it to investors. It’s actually easy to find a low-cost fund and set up a brokerage account, even if you only have basic knowledge of what to do. Then you’ll be able to enjoy the solid performance of the S&P 500 over time.
Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making an investment decision. In addition, investors are advised that past investment product performance is no guarantee of future price appreciation.