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Index funds are one of the easiest ways to invest — here's how they work

Index investing allows you to put money in the largest U.S. companies with low fees and minimal risk.

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Plenty of people shy away from investing because of fear.

In fact, a survey from Ally Invest found that 65% of adults say they find investing in the stock market to be scary and/or intimidating. Whether it's the concern you'll make a bad investment and lose money or a lack of access to quality investing advice, at the end of the day that fear is holding you back from really growing your net worth.

The good news is there are many easy ways to invest; you don't have to worry about picking individual stocks, and hiring an expensive advisor isn't always necessary. One of the easiest ways to get started investing is through index funds.

How index funds work

Index funds are investment funds that follow a benchmark index, such as the S&P 500 or the Nasdaq 100.

When you put money in an index fund, that cash is then used to invest in all the companies that make up the particular index, which gives you a more diverse portfolio than if you were buying individual stocks.

Let's use the S&P 500 as an example. The S&P 500 is one of the major indexes that tracks the performance of the 500 largest companies in the U.S. Investing in an S&P 500 fund (one of the most popular) means your investments are tied to the performance of a wide range of companies.

Because the goal of index funds is to mirror the same holdings of whatever index they track, they are naturally diversified and thus hold a lower risk than individual stock holdings. Market indexes tend to have a good track record, too. Though the S&P 500 certainly fluctuates, it has historically generated nearly a 10% average annual return over time for investors. (Just remember that future returns are not guaranteed.)

Index investing is a form of passive investing

Index investors don't need to actively manage the stocks and bonds investment as closely since the fund is just copying a particular index. This is why index funds are known as passive investing — and it's what sets them apart from mutual funds.

Mutual funds are actively managed by fund managers who choose your investments. The goal with mutual funds is to beat the market, while the goal with index funds is simply to match the market's performance. Since index funds don't require daily human management, they have lower management costs (called "expense ratios") than mutual funds. The money saved in fees by investing in an index fund over a mutual fund can save you lots of money in the long term and in turn help you make more money.

A common strategy for many investors who have a long investment timeline is to regularly invest money into an S&P 500 index fund (known as dollar-cost averaging) and watch their money grow over time.

Get started index investing with a brokerage account

Some of the top index funds are those that track the S&P 500 and have low costs. For example, Charles Schwab's S&P 500 Index Fund (SWPPX) is a straightforward option with no investment minimum. Its expense ratio is 0.02%, meaning every $10,000 invested costs $2 annually. Passive, or index funds, generally have a 0.2% expense ratio, so this is notably low.

For an option with no expense ratio, consider the Fidelity ZERO Large Cap Index (FNILX). Though the fund doesn't technically track the S&P 500, the Fidelity U.S. Large Cap Index tracks large capitalization stocks, which the website says, "are considered to be stocks of the largest 500 U.S. companies."

To invest in an index fund, you'll need to open a brokerage account, a traditional IRA or a Roth IRA (you can often choose to invest in index funds through your employer's 401(k) too). Once your account is open and funded, you can choose from a number of different index funds, like an S&P 500 fund, a fund that tracks government bonds or a fund that tracks international stocks.

Also, consider using a robo-advisor like Wealthfront and Betterment (which Select rated highly on our list of the best robo-advisors), which will invest in a handful of index funds and ETFs based on your risk tolerance and investment timeline. Robo-advisors will automatically rebalance your portfolio based on market conditions and have much lower fees than traditional financial advisors.

Editorial Note: Opinions, analyses, reviews or recommendations expressed in this article are those of the Select editorial staff’s alone, and have not been reviewed, approved or otherwise endorsed by any third party.
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