An index fund is a type of investment fund that tracks a market index—like the S&P 500—by holding all (or a representative sample) of the stocks in that index. Instead of trying to beat the market through stock picking, index funds simply match the market’s performance at very low cost.
Index funds are widely considered the smartest investment for most people. Here’s why, and how to get started.
What Is an Index Fund?
An index fund is designed to replicate the performance of a specific market index. The most common examples:
| Index | What It Tracks | Example Fund |
|---|---|---|
| S&P 500 | 500 largest US companies | Vanguard 500 Index (VFIAX) |
| Total Stock Market | Entire US stock market (~4,000 stocks) | Vanguard Total Stock Market (VTSAX) |
| Total International | Non-US stocks worldwide | Vanguard Total International (VTIAX) |
| Total Bond Market | US investment-grade bonds | Vanguard Total Bond Market (VBTLX) |
When you buy an S&P 500 index fund, you own a tiny piece of all 500 companies—Apple, Microsoft, Amazon, and 497 others—in a single investment.
How Index Funds Work
Passive vs Active Management
Active funds employ managers who try to pick winning stocks and beat the market. They research, analyze, and trade frequently.
Index funds (passive) simply buy and hold whatever is in the index. No research teams, no stock picking, no frequent trading. This is the core of a passive investing strategy.
Why Passive Wins
Over 15-year periods, approximately 90% of actively managed funds underperform their benchmark index after fees. The reasons:
- High fees eat returns — Active funds charge 0.5-1.5% annually; index funds charge 0.03-0.20%
- Trading costs add up — Frequent buying and selling creates expenses
- Beating the market is mathematically difficult — For every winner, there’s a loser
A 1% annual fee difference costs you hundreds of thousands of dollars over a career of investing.
Index Fund Fee Example
| Fund Type | $100,000 invested for 30 years at 7% return | Final Amount |
|---|---|---|
| Index fund (0.04% fee) | After fees | $756,000 |
| Active fund (1.00% fee) | After fees | $574,000 |
| Difference | $182,000 |
You’d have $182,000 more simply by choosing the lower-cost option.
Why Index Funds Are Recommended for Most Investors
1. Instant Diversification
A single total stock market index fund owns thousands of companies across every industry. If one company fails, it barely affects your portfolio.
2. Low Costs
The best index funds charge 0.03-0.10% annually. That’s $3-$10 per year for every $10,000 invested.
3. Tax Efficiency
Index funds trade infrequently, which means fewer taxable events. This matters significantly in taxable accounts.
4. Simplicity
You don’t need to research stocks, time the market, or monitor your portfolio constantly. Buy, hold, and let it grow.
5. Predictable Performance
You’ll get approximately the market return, minus minimal fees. No wondering if your fund manager will outperform.
6. Warren Buffett’s Endorsement
Warren Buffett, one of history’s greatest investors, has repeatedly said most people should invest in low-cost S&P 500 index funds. He even bet (and won) $1 million that an S&P 500 index fund would outperform a selection of hedge funds over 10 years.
Types of Index Funds
By Investment Type
Stock Index Funds:
- US large-cap (S&P 500)
- US total market (entire US)
- International (non-US stocks)
- Emerging markets (developing countries)
Bond Index Funds:
- Total bond market
- Treasury bonds
- Corporate bonds
- Municipal bonds
By Structure
Mutual Funds:
- Purchased at end-of-day price
- Often have minimum investments ($1,000-$3,000)
- Can set up automatic investments easily
ETFs (Exchange-Traded Funds):
- Trade throughout the day like stocks
- Usually no minimum investment (buy 1 share)
- Slightly more tax-efficient
Both structures offer excellent low-cost options. The differences are minor for most investors. For a detailed comparison, see our guide on ETFs vs mutual funds.
How to Choose an Index Fund
Step 1: Decide What to Index
For most beginners, these three options cover everything:
- US Total Stock Market — Broadest US exposure
- S&P 500 — 500 largest companies (most popular)
- Target-Date Fund — Automatic mix of stocks and bonds based on retirement year
Step 2: Compare Expense Ratios
The expense ratio is the annual fee. Lower is better.
| Rating | Expense Ratio |
|---|---|
| Excellent | Under 0.10% |
| Good | 0.10% - 0.20% |
| Acceptable | 0.20% - 0.50% |
| Avoid | Over 0.50% |
Step 3: Check the Tracking Error
Good index funds closely match their benchmark index. Look for tracking error under 0.1%.
Step 4: Consider Fund Size
Larger funds (over $10 billion in assets) tend to be more stable and efficient.
Recommended Index Funds
S&P 500 Index:
- Vanguard 500 Index Fund (VFIAX) — 0.04%
- Fidelity 500 Index Fund (FXAIX) — 0.015%
- Schwab S&P 500 Index Fund (SWPPX) — 0.02%
Total US Stock Market:
- Vanguard Total Stock Market (VTSAX) — 0.04%
- Fidelity Total Market Index (FSKAX) — 0.015%
- Schwab Total Stock Market (SWTSX) — 0.03%
Total International:
- Vanguard Total International (VTIAX) — 0.12%
- Fidelity Total International (FTIHX) — 0.06%
How to Start Investing in Index Funds
Step 1: Open an Investment Account
For retirement savings:
- 401(k) through your employer — don’t miss the employer 401(k) match
- Roth IRA or Traditional IRA at a brokerage
For non-retirement savings:
- Taxable brokerage account
Step 2: Choose Your Brokerage
Major low-cost brokerages:
- Fidelity — Lowest-cost funds, excellent customer service
- Vanguard — Pioneer of index funds, investor-owned
- Charles Schwab — Good all-around, strong banking integration
All three offer excellent index funds with nearly identical low costs.
Step 3: Select Your Funds
For simplicity, you can use a single fund:
One-fund solution:
- Target-date retirement fund (automatically diversified)
- OR Total world stock market fund
Three-fund portfolio:
- US total stock market (60%)
- International stock market (20%)
- US bond market (20%)
Adjust percentages based on age and risk tolerance (more bonds as you age).
Step 4: Set Up Automatic Investments
Schedule recurring purchases:
- Align with your paycheck
- Start with whatever you can afford
- Increase amount with each raise
Step 5: Don’t Touch It
The biggest mistake investors make is interfering. Market drops are normal. Stay invested.
Common Index Fund Mistakes
Mistake 1: Paying High Fees
An “index fund” with a 0.80% expense ratio is a bad deal. True index funds cost under 0.10%.
Mistake 2: Over-Diversifying
You don’t need 15 different index funds. A total stock market fund already owns thousands of companies.
Mistake 3: Trying to Time the Market
Waiting for a “dip” to invest usually backfires. Markets go up more than down. Invest consistently.
Mistake 4: Checking Too Often
Daily portfolio monitoring leads to emotional decisions. Check quarterly or annually.
Mistake 5: Selling During Downturns
Market drops of 20-30% happen regularly. Selling during drops locks in losses. Stay the course.
Index Funds vs Individual Stocks
| Factor | Index Funds | Individual Stocks |
|---|---|---|
| Diversification | Built-in (thousands of companies) | Must build yourself |
| Research required | Minimal | Extensive |
| Time commitment | Minutes per year | Hours per week |
| Risk | Market risk | Company-specific risk |
| Potential upside | Market returns | Unlimited (or zero) |
| Probability of success | Very high | Low (most underperform) |
For 99% of people, index funds are the better choice.
Frequently Asked Questions
Are index funds safe?
Index funds carry market risk—they go down when the market goes down. However, over long periods (10+ years), the stock market has historically always recovered and grown. They’re “safer” than individual stocks because of diversification.
How much money do I need to start?
Many brokerages have no minimum for index fund ETFs. You can start with the cost of one share ($50-500 depending on the fund). Some mutual funds require $1,000-3,000 minimums.
Should I invest in S&P 500 or Total Stock Market?
Either is excellent. The total stock market includes smaller companies not in the S&P 500, providing slightly more diversification. Performance is nearly identical long-term.
Can I lose money in index funds?
Yes, in the short term. Markets can drop 30-50% during crashes. However, if you hold through downturns, historical evidence shows markets recover. The key is time horizon—don’t invest money you’ll need within 5 years. Keep short-term money in an emergency fund instead.
How often should I invest?
Regular intervals (monthly, bi-weekly) work best. This is called dollar-cost averaging. Automate it so you don’t have to remember.
What about bonds?
Most young investors (under 40) can be 90-100% in stock index funds. As you approach retirement, gradually add bond index funds for stability. A common rule: subtract your age from 110 to get your stock percentage.
Key Takeaways
Index funds are the foundation of smart investing:
- Match the market instead of trying to beat it
- Low fees compound into massive savings
- Instant diversification reduces company-specific risk
- No stock picking required — let the index do the work
- Outperform most active managers over time
- Simple to buy and hold for decades
Your Action Plan
- Open an investment account (IRA or brokerage)
- Choose a low-cost brokerage (Fidelity, Vanguard, or Schwab)
- Select a total stock market or S&P 500 index fund
- Set up automatic monthly investments
- Don’t look at it frequently
- Increase contributions with each raise
- Hold for decades
Index funds won’t make you rich overnight, but they’re the most reliable path to building long-term wealth. Thanks to compound interest, even $50 per month grows significantly over time. Start today with whatever amount you can.
Written by Maira Azhar. Fact-checked by Usman Saadat.