The Standard & Poor’s 500 index funds are among the most popular investments today – and it’s no wonder why. The S&P 500 index on which these funds are based has returned an average of about 10 percent per year over time and represents hundreds of America’s best companies. With an S&P 500 index fund, you own the market, rather than trying to beat it.
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 need to know to get started.
Index funds explained
An index fund is a type of investment fund – a mutual fund or an ETF – that is based on an index. An index is a preset collection of stocks (or bonds), and an index fund merely mimics the composition of the index, rather than trying to pick which stocks will perform best. An index fund is therefore a passively managed investment, where the investments are only adjusted if the underlying index changes.
An index fund is usually created around a specific theme. For example, there are indexes for companies based on their geographic location (such as the US), their size (large companies, such as in the S&P 500), their sector (such as semiconductors or healthcare), and whether they pay dividends. An index can also consist only of bonds, or only of bonds of a certain quality and term. The best index funds can deliver excellent returns over time.
How to Invest in an S&P 500 Index Fund
It’s surprisingly easy to buy an S&P 500 fund. You can set up your account to buy the index fund on autopilot so you almost never have to check the account, or you can enter your trades manually.
1. Find your S&P 500 index fund
It’s actually easy to find an S&P 500 index fund, even if you’re new to investing.
Part of the beauty of index funds is that an index fund will have the exact same stocks and weightings as another fund based on the same index. In that sense, it would be like choosing between five McDonald’s restaurants that serve exactly the same food: which one would you choose? You’ll probably choose the restaurant with the lowest price, and the same usually applies to index funds.
Here are two important criteria for selecting your fund:
- Cost ratio: To determine if a fund is cheap, you need to look at its expense ratio. These are the costs that the fund manager charges you during the year for managing the fund, as a percentage of your investment in the fund.
- Sales tax: If you invest in mutual funds, you also want to know if the fund manager charges you a sales charge, which is a fancy name for a sales commission. You want to avoid these types of expenses completely, especially if you’re purchasing an index fund. ETFs do not charge sales fees.
S&P 500 index funds have some of the lowest expense ratios on the market. Index investing is already cheaper than almost any other form of investing, even if you do not choose the cheapest fund. Many S&P 500 index funds charge less than 0.10 percent annually. In other words, at that rate you’ll only pay $10 per year for every $10,000 you invest in the fund.
Some funds are even cheaper than that. Here are five of the best S&P 500 index funds, including one that’s completely free, as well as some other top index funds.
When investing, paying more does not always translate into a better return. In fact, the relationship between fees and returns is often inverse. Because 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 pay. So costs are an important consideration here.
Select your fund and note the ticker symbol, an alphabetical code of three to five letters.
2. Go to your investment account or open a new one
Once you’ve selected your index fund, you’ll want to access your investment account, whether it’s a 401(k), an IRA, or a regular taxable investment account. These accounts allow you to buy mutual funds or ETFs, and you may even be able to buy stocks and bonds later, if you choose.
If you don’t have an account, you’ll need to open one, which you can do in 15 minutes or less. You want one that suits the type of investments you plan to make. If you are buying a mutual fund, try to find a broker that allows you to trade your fund without transaction fees. If you’re buying an ETF, look for a broker that offers commission-free ETFs, a practice that has become the norm.
The best brokers offer thousands of ETFs and mutual funds with no trading fees. Here is Bankrate’s list of the best brokers for beginners.
3. Determine how much you can afford to invest
You don’t have to be rich to start investing, but you do need to have a plan. And that plan starts with figuring out how much you can invest. You want to add money to the account regularly and aim to keep it there for at least three to five years so that the market has enough time to rise and recover from any major downturns.
The less you have to invest, the more important it is to find a broker that offers you low fees, because that’s money that could otherwise end up in your investments.
Once you know how much you can invest, you can transfer that money to your investment account. Then set your account in such a way that you regularly transfer a desired amount from your bank weekly or monthly. Or you can set up your 401(k) account to transfer money from each paycheck.
4. Buy the index fund
Once you know which S&P index fund you want to buy and how much you can invest, go to your broker’s website and initiate the trade.
Stick to the broker’s simple trade entry form, which often appears at the bottom of the screen. Enter the fund’s ticker symbol and how many shares you want to buy, based on how much money you have deposited into the account.
If you can regularly transfer money to the investment account, many brokers allow you to set up an investment schedule to purchase an index fund on a periodic basis. This is a great option for investors who don’t want to remember to place a trade regularly. You can set it and forget it.
As a result, you can enjoy the benefits of dollar-cost averaging, which can reduce risk and increase your returns.
What is the S&P500?
While there can be virtually any number of indexes, the best known are based on the Dow Jones Industrial Average, the Standard & Poor’s 500, and the Nasdaq Composite.
Of these, the S&P 500 Index is seen as the indicator for the American stock market. It includes approximately 500 of the largest companies in the United States, and when investors talk about “beating the market,” the S&P 500 is often considered the benchmark.
In contrast, the Dow Jones Industrials contains only 30 companies, while the Nasdaq Composite measures the performance of about 3,000 companies. Although the holdings in these indexes overlap, the S&P 500 contains the widest variety of companies across all sectors and is the most broadly diversified of these three indexes.
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:
- Owned by many companies: These funds allow you to own hundreds of stocks, even if you only own one share of the index fund.
- Diversification: This broad collection of companies reduces your risk through diversification. One company’s poor performance won’t hurt you as much if you own multiple companies.
- Cheap: Index funds tend to be cheap (low expense ratios) because they are passively managed rather than actively managed. As a result, more of your hard-earned dollars are invested rather than paid as fees to fund managers.
- Good prestation: Your return will essentially equal the performance of the S&P 500, which has historically averaged about 10 percent per year over long periods of time.
- Easy to buy: It is much easier to invest in index funds than to buy individual stocks because it requires little time and no investment expertise.
Here are the biggest reasons why investors have flocked to the S&P 500.
Is an S&P 500 index fund a good investment?
As long as your time horizon is three to five years or longer, an S&P 500 index fund can be a good addition to your portfolio. However, any investment can produce poor returns if purchased at overvalued prices. But that hasn’t proven to be a problem for these funds, as investors average annual returns of about 10 percent over long periods of time.
Consider buying into the fund over a period of time using a method known as dollar-cost averaging. By doing this you spread out buying points and avoid the practice of ‘timing the market’. This approach will allow you to take advantage of any market downturns that occur from time to time.
In short
Buying an S&P 500 index fund can be a wise decision for your portfolio, which is one reason Warren Buffett has consistently recommended it to investors. It’s easy to find a low-cost fund and create an investment account, even if you only have basic knowledge of what to do. Then, over time, you can enjoy the solid performance of the S&P 500.
Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making any investment decision. In addition, investors are advised that the past performance of investment products does not guarantee future price increases.
