Index fund investing should be efficient and low cost. The goal is to capture market returns less a small fee in a diversified portfolio that covers basic asset classes. When constructed correctly, an index fund portfolio provides the highest probability for reaching your long-term investing goals.
That’s what an index fund portfolio should be — however, that’s not what many are. Many portfolios I review resemble a garbage dump. There’s little rhyme or reason to the structure, they hold redundant funds in some asset classes and are void of funds in other asset classes, and fund expenses are often several times higher than the alternatives. It adds up to extra cost and loss of return.
There is no reason to weigh down a portfolio with lots of extraneous baggage. Unfortunately, there are investment advisers who prefer complexity to simplicity because they believe it justifies their high management fee. Don’t be fooled by this. Stick with the basics and you’ll be better off.
Building a basic index fund portfolio is not complicated. Here are 5 tips to get you started.
- Start with the classic three-fund portfolio. A three-fund portfolio is based on two equity asset classes and one fixed income asset class. The equity portion is allocated two-thirds in a broad U.S. stock index fund and one-third in a broad international stock index fund. The bond portion is fully invested in a broad U.S. bond index. Cash is not counted in an investment portfolio, so it is not included.
- Choose plain vanilla index funds. These are the lowest cost market-following funds offered on the market. Vanguard offers the Total Stock Market Index Fund (VTSMX), Total International Stock Index Fund (VGTSX) and Total Bond Market Fund (VBMFX). These funds are also available in lower-cost Admiral Shares and exchange-traded funds (ETFs). Schwab, Fidelity, iShares, SPDR and other fund companies have competing low-cost index products.
- Select satellite funds judiciously. Satellite funds are optional add-ons to the three-fund portfolio. They are like icing on the cake. Some alternatives are real estate index funds (REITs), small-cap value funds, and perhaps inflation-protected bond funds. See The Total Economy Portfolio for ideas. If you don’t like icing and just want to stick with the basics, that’s perfectly fine also.
- Don’t over-diversify. A little icing on the cake adds flavor, at lot makes the cake sit like a rock in your stomach. Adding too many things to a portfolio increases cost and starts taking away return. For example, in a recent article titled Splitting Growth and Value Leads to a Worse Return, I discuss the futility of dividing a U.S. equity portfolio into equal positions of growth and value stocks. This adds nothing but cost.
- Stay the course. This is one of John C. Bogle’s most famous sayings. The founder of Vanguard explains time and again that the best investment results come to those who keep their expenses low and don’t waver in the face of adversity. When rough times appear, Bogle’s other famous saying is, “Don’t do something, just stand there!” Have faith and reap the rewards.
Index investing became popular over the years through a grass roots effort while Wall Street fought the idea. Then the market wizards figure out how to make money at it. They took a simple idea and added complexity and cost. Many index fund and ETF strategies on the market today involve the use of leverage and actively-managed strategies such as market-timing. These strategies are not in your best interest. They’re designed to make money from you, not for you.
Honest index fund investing is efficient and low cost. It captures market returns less a small fee. When an index fund portfolio is constructed properly, it has highest probability for reaching your long-term investing goals.