Step 4: Start With an Index Fund

Let's stop for a second for a brief review:

Step 1: You have a general idea of what it means to be a Foolish investor.

Step 2: You've gotten your personal finances in order by paying down all of your credit card debt and establishing an emergency fund.

Step 3: You've set reasonable expectations, and you're going to track your investments against the market.

Thus far, you've prepared yourself emotionally, financially, and intellectually to be an investor. By so doing, you are already significantly ahead of the majority of people participating in the stock market.

But how can that be, you ask? Simple. A huge number of investors, be they young, old, new to the market, or old hands, have never bothered to give themselves or their financial status a checkup before jumping into investing. Some others did so, but then they entrusted their money to professional management, by way of mutual funds and expensive brokers. Chances are that these decisions will hinder their future financial standing.

But you, on the other hand, are ready to jump in. So jump!

What, you're still here? You say you don't know where to put your money? Good. Very good! You pass the test. You shouldn't expect to have all of the answers yet.

In this step, we are going to look at what is the beginning point for investing for many, and the end point for many others. A significant number of individual investors have chosen to invest their money in index funds and will never have to think about investing again. They just send in their checks, and they participate in the future growth of the domestic and worldwide economy.

Let us emphasize this point. If you are comfortable investing in index funds and go no further, we applaud you. Our society seems to celebrate folks who take risks, but taking a financial risk that you are in no way prepared to take is nothing to be celebrated. Buying into an index fund and getting on the with parts of your life that you enjoy ought to be celebrated.

Index funds remain the lowest-cost, lowest-maintenance form of investing for an individual. Indexing is free from punitive management fees, and it is free from the concern that even shareholders of the most dynamic, stable, individual companies have about their investments from time to time.

There are as many reasons to invest in index funds as there are investors. Some investors lack the time, interest, or confidence in their own ability to pick and track individual stocks. This in no way makes these people inferior investors. If anything, that self-awareness makes them superior, more Foolish investors, compared to many who are out there chasing the next big thing. Just consider that 99% of the chasers are still chasing and will continue to chase.

Index-fund investing allows people to take part in the expansion of the economy -- to participate in the stock market -- in a low-effort, lower-risk way. Those who get to this point and determine that their best choice is to index are to be saluted.

Indexing also serves as a backstop for people who choose to invest in individual companies. One particularly Foolish method is the "Index Plus a Few" strategy, in which the investor places the majority of his or her portfolio into an index fund and then carefully selects a couple of stocks to augment the overall performance.

We'll now discuss the myriad index products that exist, beginning with the granddaddy of them all.

The S&P 500 index fund
Over the long term, the S&P 500, an index of 500 of the largest and most profitable companies in the U.S., has risen an average of around 10% annually, with dividends reinvested.

That means that if you invested $10,000 into the S&P 500 back before the Great Depression, your account would now be worth upwards of $20 million. Sounds great, huh? But most people who have invested in equity (remember, "equity" means "stock") mutual funds haven't pocketed that market average, or anything close to it -- unless they have invested in an index fund.

According to Princeton University's Burton Malkiel, the average actively managed mutual fund has returned 1.8% per year less than the S&P 500. That 1.8% is not much higher than the average expense ratio (read: annual fee) of these actively managed funds. It may not seem like a great deal, but it is, over time. That aforementioned $20 million would be worth less than $6 million, given a return that's just 1.8% lower per year.

Furthermore, actively managed funds generally have higher turnover (the amount a manager trades in or out in a given year), the capital gains taxes of which are passed on to the fund's shareholders on an annual basis. The lower the turnover, the lower the annual tax bill. Index funds generally have turnover of less than 5% per annum. In contrast, many actively managed funds have turnover rates of 60% or more.

If you're picking a mutual fund for your tax-deferred 401(k) or 403(b) plans, or for an IRA, and if there is an index fund available in your list of choices, the Foolish thing to do would be to make it your only choice.

Learn to love Spiders
The best-known index mutual fund is the Vanguard S&P 500 index fund. But there are many other choices for people who wish to purchase index-tracking products on a real-time basis. Standard & Poor's Depositary Receipts, or "SPDRs" (pronounced "Spiders"), are the best known. These kinds of products are known as exchange-traded funds, or ETFs. Spiders are purchased through a broker (we'll learn about that in Step 6), just as if they were stocks, and they trade under the ticker symbol SPY.

Indexing beyond the S&P 500
Index funds aren't just for the S&P 500. If you can name a measurement or a sector of the market, then somebody has probably slapped an index fund on top of it. Some indices include the Russell 2000 (an index of 2,000 smaller-company stocks), the Wilshire 5000 (the entire stock market -- in reality there are about 9,000 publicly traded companies, but the "Wilshire 8,934" just wouldn't sound too good), and the Dow Jones Industrial Average (the 30 stocks that make up the Dow).

The list of different indices that have mutual funds tracking them is getting longer all the time. You can purchase these through fund companies that offer index funds, or you can buy them as ETFs. Want to buy the companies in the Nasdaq 100? The major index for Malaysia? You can find an ETF for both.

We like all of these products. Except for one thing ...

The spiraling number of index-based funds and products has added complication to an area of investing that used to be simple. "Index fund" used to mean the Vanguard S&P 500 product, almost by default. We still believe that this individual fund, and its cousin, the Spider, are among the best long-term products for index investors. But if you want to add some international exposure or some additional technology exposure, there are other options.

Be careful about what some companies are selling as "index funds." Putting your money into a broad-market index fund should deliver great results to the long-term shareholder, because index funds keep costs so low. The Vanguard 500 index fund has annual costs of roughly 0.15%. But that doesn't keep other index funds from charging much more -- some have expenses of 1% or higher!

The only reason to move beyond the Vanguard 500 index fund, or another low-cost index fund, is if you believe you can beat its performance after all of your investment costs -- research reports, fax newsletters, financial newspapers, business magazines, and so on -- have been deducted. If you can't beat the index, you'd better just join it ... and keep adding savings to it each year. In the decades ahead, you (and your heirs) will be happy you did.

Some index funds will allow you to establish a regular account for an initial investment of as little as $500 if you set up an automatic investment plan and add $50 a month thereafter. If you want to get started investing with an even lower amount, make sure to pay close attention to Step 5.

And finally, a word to the worried: If the few steps you've read so far are already making your head spin, and you're fretting about how you'll ever get your financial ducks in a row, stop fretting. Keep reading, and don't expect to master all of this at once.

To see the rest of the 13 Steps, follow the links at the bottom of this article.