Index Funds Explained: The Easiest Way to Build Wealth
If there's one investment that financial experts nearly universally recommend, it's index funds. Warren Buffett has publicly advised most investors to use them. Nobel laureates have built careers studying why they work. And the data consistently shows that index funds outperform the majority of actively managed funds over the long term. Here's why — and how to get started.
What Is an Index Fund?
An index fund is a type of mutual fund or exchange-traded fund (ETF) designed to track a specific market index. An index is simply a list of stocks or bonds selected to represent a particular market or sector.
For example, an S&P 500 index fund holds shares of all 500 companies in the S&P 500 index, in proportion to their market value. When you buy one share of an S&P 500 index fund, you effectively own a tiny piece of 500 of the largest U.S. companies.
How Index Funds Work
Unlike actively managed funds, where a fund manager picks stocks trying to beat the market, index funds simply mirror an index. This "passive" approach means:
- Lower costs: No highly paid stock-picking team means lower expense ratios — often 0.03–0.20% annually, compared to 0.50–1.50% for actively managed funds.
- Broad diversification: One fund gives you exposure to hundreds or thousands of companies.
- Consistent performance: Over any 15-year period, the majority of actively managed funds underperform their benchmark index after fees.
Why Index Funds Outperform Most Active Funds
It seems counterintuitive — how can not trying to beat the market produce better results? The answer is fees and consistency. Active fund managers charge higher fees, and those fees compound over time, dragging down returns. Additionally, while some active managers outperform in any given year, very few do so consistently over decades. After fees, most investors are better off with a low-cost index fund.
Popular Types of Index Funds
Total Stock Market Index Funds
These track the entire U.S. stock market — large, mid, and small-cap companies. They offer the broadest domestic stock exposure in a single fund.
S&P 500 Index Funds
These track the 500 largest U.S. companies by market capitalization. Because large-cap stocks dominate the total market, S&P 500 funds and total market funds perform very similarly.
International Index Funds
These provide exposure to companies outside the U.S., offering geographic diversification. A total international fund covers developed and emerging markets.
Bond Index Funds
These track bond markets, providing lower-risk, income-generating investments. They're useful for balancing a portfolio's stock exposure, especially as you approach retirement.
Building a Simple Index Fund Portfolio
A classic beginner portfolio uses just two to three index funds:
- 60–80% in a total U.S. stock market or S&P 500 index fund
- 10–20% in an international stock index fund
- 10–20% in a bond index fund (increase this as you age)
This simple mix provides broad diversification across geographies and asset classes. As you approach retirement, gradually shift toward a higher bond allocation to reduce volatility.
How to Get Started
- Open a brokerage account or use your retirement account. Most 401(k) and IRA plans offer index fund options.
- Choose low-cost funds. Look for expense ratios below 0.20%. Major providers like Vanguard, Fidelity, and Schwab offer excellent options.
- Set up automatic investments. Consistency matters more than timing. Automate your contributions to invest on a regular schedule.
- Rebalance annually. Once a year, check if your portfolio has drifted from your target allocation and adjust as needed.
Common Questions
Can I lose money in index funds?
Yes — in the short term. Stock index funds can and do decline in value during market downturns. However, over long periods (10+ years), broad market index funds have historically always recovered and grown. The key is staying invested through downturns rather than selling in panic.
How much do I need to start?
Many index funds and ETFs have no minimum investment. You can start with as little as the price of one share — sometimes under $50. For more on getting started with investing, see our beginner's guide.
Index funds are the closest thing to a "set it and forget it" investment strategy. They're simple, low-cost, and effective. For most people, they're the best way to build long-term wealth.
