What is an index fund and how does it work?

Handpicking stocks and bonds is one way to invest in the stock market. Index funds, which allow you to invest in a wide array of stocks all at once, are another.

If you're not well-versed in the market, index funds can be a good way to diversify your portfolio without putting in a lot of effort, capital or research. Still, they're not right for everyone. Make sure you speak with a financial adviser who can help guide you through the process.

Are you considering investing in an index fund? Here's what you need to know.

What is an index fund?

An index fund is a grouping of stocks, bonds or other securities. They're designed to mirror the performance of a particular market index — like the S&P 500 or the Dow Jones Industrial Average, for example.

When you invest in an index fund, you're purchasing shares in all or some of the companies within that index. This allows you to spread your investments across many sectors and industries without having to handpick individual stocks or actively manage your portfolio. 

Most index funds are passively managed, which means there's usually not a fund manager picking or trading stocks within them on a regular basis. They're also a popular retirement tool, so you'll often see them as part of your employer-sponsored 401(k) and IRA options. 

Are you sufficiently prepared for retirement? If you're unsure, then you should consider diversifying your plans. A Roth IRA can be a good place to start. Get started today!   

Pros

There are several benefits to investing in an index fund. 

• They don't require a lot of market knowledge, research or risk: Since you're only buying small shares of each company, there isn't as much room to fail. 
• They have a very low cost of entry. With some funds, you can get started with just a $1 investment.
• They're also great for diversifying your portfolio. You can expand your portfolio. Plus, they generally deliver solid returns over time. Vanguard's S&P 500 index fund, for example, has delivered returns of around 14% annually since its inception. Meanwhile, Schwab's index fund has been around 11% for the past five years.

If you're not sure how to invest your money, consider speaking to a financial adviser or investment professional. They can help you make the right decision for your goals and budget.

Cons 

However, there are some drawbacks to index funds.

• They might limit how much your money can grow. Because they're not actively managed, you won't be able to take advantage of ebbs and flows in the market. This could limit your gains in the short run.
• They're pretty inflexible. If the market your fund is tied to takes a turn, there's not much you can do. You'll need to be prepared to ride out the dip until things recover, which could be months or even years.

Steps to investing in index funds

If you're interested in investing in index funds, there's a quick and easy way to get started:

1. Open a brokerage account, 401(k) or IRA. Your employer may also offer one of these, so be sure to ask your HR or benefits department if you need help.
2. Choose an index and start purchasing. Once you've established your account, you can fund it, choose the index you'd like to invest in, and purchase shares.  If you're not comfortable picking which funds to invest in, most brokerages have a robo-advisor tool you can use. These allow you to pick your risk level and then set certain goals for growth. They then build you a portfolio based on those numbers. 

Alternatives 

If an index fund isn't right for your investing goals, there are plenty of other ways to grow your wealth in the markets. Mutual funds, for example, are an option. These are actively managed funds that aren't tied to a specific market but still allow you to invest in a variety of stocks and bonds all at once.

You can also buy individual securities or invest in things like cryptocurrency, real estate or gold.