What are Index Funds and why are they a great way to start investing for beginners?

Note the following content is intended to be educational but it does contain promotional material for Kaldi.

Index funds. Two words to make you run a mile. But stick with us because you don’t need to be a stock market bro (or sis) to make this investment type work for you, and it’s not as complicated as you might think.

We’ve got the ins, out and just about everything else you need to know about why you should consider using index funds as a way to reach your savings goals. So read on and see why it might be time to do some indexing.

But first … a little word from our legal team

Investing can be a super smart way to grow your money, but it’s important to remember that there are no guarantees. Any information provided here is designed to help you learn more about the topic and shouldn’t be taken as financial advice. We’re not Martin Lewis unfortunately.

Okay, with that in mind, let’s get to it.

What are index funds?

If you’ve ever had Celebrations before, then you’ve got more in common with index funds than you think. With Celebrations, you get a Mars, Twix, Maltesers, Bounty (yuck) and Milky Way all in one box. It’s the same with index funds, only instead of sweet, sweet chocolate, you get stocks in a bunch of different companies.

In layman’s terms, index funds are a box holding tons of different stocks in one package. But not just any random stocks—the fund contains shares from the biggest, most well-known companies that make up a major ‘index’ like the S&P500, which is the 500 largest companies in the U.S..

Instead of individual stocks in the likes of Apple, Amazon, Google, etc., an index fund lets you own a tiny slice of all those giant companies combined into one basket.

Of course, you can’t eat index funds. Instead, you get to own a little bit of the major market players all bundled together.

The big advantage of that is that index funds are super diversified right off the bat. You're not putting all your eggs in one basket by betting on a single company's success. Your money is spread across dozens or hundreds of stocks.

Plus, index funds simply try to match the performance of their market index rather than beat it through active stock trading. This makes them generally lower-cost than funds with higher fees.

So in just one low-cost basket, you get instantly diversified across all the heavyweights without the hassle of picking individual stocks yourself. Just set it and forget it while your index fund tracks the long-term growth of the overall market.

Why index funds are a good way for people to start investing

Isn’t investing all about beating the market, you might ask? And if you’ve ever watched the Wolf of Wall Street, or the 80s classic, Wall Street, you might be right. But alas, investing doesn’t typically have a Hollywood movie plotline.

The beauty of index funds lies in their simplicity and low cost. Index funds are an excellent example of passive investing, which makes them perfect for beginners. In other words, you don't need to stress over picking the right stocks.

But that doesn’t mean index funds are only for newbies. No, no. Seasoned investors are also drawn to index funds because of their lower fees.

Many other investment types involve higher fees to cover the expensive salary of a stock-picking expert (or even a team of experts or fund managers) to oversee your fund's investment.

The problem is that over time, the majority of funds managed by these experts and fund managers often fail to beat the return of index funds and their close relatives, ETFs (more on that shortly).

That’s all well and good, but how much returns will I get?

If you're curious about the kind of returns you might see, let's be clear that no one has the ability to see into the future. Indeed, predicting exact figures is challenging (we have the unpredictability of the market's performance to thank for that).

To get a better idea of the kind of return you might expect, however, let's look back at the history of the S&P500. In this instance, index returns delivered an average of 11.3% between 1957 and 2023.

Sure, past performance doesn't guarantee future results, but hopefully you get the idea. An 11.3% return isn’t to be sniffed at.

Great! Where do I sign up?

Whoa there. Before you go and do all the investing, it’s important to be balanced. There are downsides, such as index funds that have delivered terrible returns over long periods because the underlying stock market index has struggled.  

For instance, even though, generally speaking, the results of the same S&P 500 were good, they hit a peak in 1968 and took 24 years to recover. So, yeah.

Oh, so I shouldn’t get an index fund?

We’re certainly not saying that, but if you have a low tolerance for risk, you might be wondering how to invest without betting the entire farm. The easiest solution is to invest in Global Index Funds— but, again, more on that later.

How about that 11.3%?

The truth is that there are many ways to invest, and an index can be a smart option as long as you do your due diligence. Remember that 11.3% return?

Well, at the time of writing, the top easy-access savings account in the UK was offering just over 5% interest. So, by comparison, 11.3% is excellent and will do way more than your standard savings account. That said, this is a historical figure as an average for one market since 1957 excluding fees and within average numbers there is a wide range of ups and downs. As ever past performance shouldn’t be used as an indicator for future growth, whilst fees have an impact on performance.

Just keep in mind that bank rates have been at their highest in over a decade, which plays a huge role in driving up savings interest rates (which used to be much lower).

This makes something like the S&P 500attractive to many investors who are willing to pass up on the guaranteed interest earned on a cash savings account for an opportunity to invest in index funds that might offer a greater return in the long term.

Sounds good. But how do index funds work?

Great question. The key thing to remember about index funds is that there are literally thousands to choose from, and you shouldn’t freak out as soon as you see the massive barrage of names.

So, let's break this down in a more digestible way:

• First, start by working out what you want to invest in. Investing in a global index fund basically means investing in all the big global companies accessible on the stock market.
• Alternatively, you may wish to invest only in 'Global Developed Markets'—don't let this term confuse you. It just refers to developed markets in high-income economies like the UK, the USA, Japan, etc.
• Similarly, you might stumble across the term 'Global Emerging Markets', which refers to, you guessed it, markets in countries that have seen a surge in recent economic development. China, for example.
• These markets may be growing faster than developed countries but sometimes the rules and regulations around their investment scene can be a bit more, er, emerging. So, these index funds generally are seen as higher risk.
• That said, index funds are available covering all sorts of categories: large companies, small companies, One country, lots of countries, or even specific industries like technology or ESG. You can sometimes even buy index funds in particular currencies, too.

Row, row, row your boat

Imagine you're sailing in a boat, and you've set your course to follow another boat. As the lead boat moves, you adjust your path to stay in line. That's how an index fund operates—it tracks the performance of a specific index, providing returns that mirror the market whether it goes up or down.

Most index funds invest in all the companies which are listed on the index they track. This means they hold a little bit of each stock or bond in the index, and that is how they replicate its performance.

Once you’ve learned the basics, you can start to become more adventurous. Just remember that risk and reward are two sides of the same coin. In other words, the funds offering the biggest rewards if things go well are often the same ones where you could lose the most money if things go wrong.

What are the different types of index funds?

When it comes to passive funds, there are two main options: Index Funds (which they call Mutual Funds in the USA) and Exchange Traded Funds (ETFs).

Exchange traded funds are investment funds based on a preset basket of stocks or index. Both track specific indexes but differ in how they’re structured and traded.

Index Mutual Funds

These are funds designed to track a specific market index. You buy shares directly from the fund company or through a broker, but trades only happen a day after the market closes. Although this might seem less flexible, it's a solid choice for long-term growth due to features like automatic dividend reinvestment.

What’s that, you ask? It allows investors to automatically re-invest the cash dividends they've earned from the fund to purchase additional shares in the same fund.

Index ETFs

On the other hand, index ETFs trade like individual stocks on exchanges. You can buy and sell shares throughout the day, offering more flexibility and higher liquidity. Plus, many brokers now allow you to buy fractional shares of ETFs, making it easy to start investing with smaller amounts. This is something we at Kaldi really like as it debunks the myth you need to be rich to invest, which is just another barrier to many people considering making their first investment.

How about those index funds benefits?

So, what makes index funds so attractive? Here are the big ones most people are drawn to.

Diversification

Remember the Celebrations and the Bounty no one likes? If you don’t want it, just leave it and go for the one you want? It’s the same for index funds—if one doesn't hit the mark, you still have plenty of other options. They spread your investment across multiple sectors and stocks, resulting in a lower risk.

Low costs

Who doesn't love a good bargain? Index funds have lower fees because there's no active stock picking involved. This means more of your money stays invested, which can lead to higher returns over time.

Potential drawbacks of index funds

No investment is a surefire hit, and it’s he same with index funds. One is the lack of control, as you can't pick which companies are in the index. Another is they follow the market down during downturns. There's no built-in protection against market drops, but remember the goal is long-term growth. Those downturns might hit hard, but patience can pay off.

Getting started with index funds

Should you decide that index funds are the right choice for you, you’ll probably want to know where to get started.

Choose an index

First, decide which market index you want to track. Pick an index that aligns with your investment goals, which could be the S&P 500 for broad market exposure, the NASDAQ for tech-focused investments, or the FTSE 100 for UK-based companies.

Select a fund

Next, choose an index fund that tracks your chosen index. Look for funds with low costs, good performance and a reputable provider. At this point, it's worth highlighting that Kaldi will offer funds from Fidelity, Vanguard, Legal and General, Royal London and HSBC.

Do some research to find the fund that best fits your needs. If this feels like a stretch, keep reading, as we might just have a solution.

Open an account

Finally, open a brokerage account to buy your index fund shares. You can do this through a brokerage platform, directly with a mutual fund company, or for an easy life you can join Kaldi. Of course we’re biased. What were you expecting?

A bit about Kaldi

Kaldi is an incredibly competitive option, with no minimum investment limits and a wide selection of index funds at the same or lower price than if you went to the fund providers themselves. We even offer cashback at over 170 UK supermarkets and high street brands that you can auto-invest into index funds from your everyday shopping.

This means every time you shop, you’re saving money and building your investment portfolio. It’s an effortless way for anyone looking to grow their wealth over time. If you’re down with the idea of making your spending work for you, Kaldi is the way to go—Sign up on Kaldi’s waitlist to start multiplying your savings when we go live.

Regardless of your choice, always compare costs and features to find the best option for you.

Practical tips for new investors

As you start your index fund investing journey, consider the advantages of investing in affordable index funds, such as low fees and access to broad market exposure.

It's also worth keeping these tips in mind:

Think long-term

Investing is a marathon, not a sprint. Stay invested over time to benefit from compounding   Investing in index funds can smooth out short-term market uncertainty and help you build substantial wealth over time.

Diversify

Don't put all your eggs in one basket. Spread your investments across different index funds to reduce risk. This could mean investing in multiple funds that track different indexes or sectors, providing a broader safety net.

Be patient

Successful investing isn’t about timing the market but about time in the market. Stick to your plan and watch your investments grow. Markets will have ups and downs, but patience and persistence can pay off in the long run.

Important disclaimer from the legal team (again)

All investments carry risk, including the risk of loss of principal. Past performance is not indicative of future results. Index funds may not be suitable for everyone. Consider your own financial situation and investment goals, and seek independent financial advice if needed.

Wrapping up: Indexing

There you have it—a comprehensive beginner's guide to index funds. They offer a simple, cost-effective way to diversify your portfolio and potentially earn solid returns over the long term. Whether you're a novice or a seasoned investor, index funds can help you achieve your financial goals.

So, if you're ready to start building wealth the smart way, check out index funds, and why not choose Kaldi as the partner to help you get started? Your future self will thank you.