If you're just starting out as an investor you've probably heard similar advice from everyone from online financial influencers to your dad to the likes of Warren Buffett: "Just invest in an index fund." Generally speaking, it's a pretty good plan. For one thing, index funds are cheap. Because these funds, which track the performance of a market index, don't have high-priced managers at the helm, they come with little to no fees for the investor.
And research has shown that those active managers, on average, may not be worth paying for — most fail to consistently outperform their benchmarks.
So great — end of article, right? Not so fast. Because as certified financial planner Brad Klontz recently pointed out on Twitter, that broad advice is less than helpful when you actually sit down to build a portfolio.
"Useless advice on social media: 'Just invest in an index fund,'" he wrote.
Scroll down the roster of available funds on your brokerage website and you'll soon learn that there are hundreds of index mutual funds and ETFs. Which ones do you buy? How many of them?
It doesn't have to be overwhelming. Here's how to put together a portfolio of index funds you can feel good about.
Use a fund with exposure to a large swath of the U.S. stock market as the foundation of your portfolio. To this end, you wouldn't be wrong to invest in a mutual fund or ETF that tracks the performance of the S&P 500. The index contains the 505 largest U.S. stocks, and is the one most often used by financial pros as a proxy for the broad stock market.
To get a truly diversified core investment, however, it pays to think bigger, says Ben Johnson, director of global ETF research for Morningstar. "Generally speaking, broader is better," he says. "In the case of U.S. stocks, I favor a total market index, which will represent about 97% of investable U.S. market cap. You're getting megacap, large-, mid-, small-, and microcap companies."
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The advantage of investing in such an index is a reduction in cost, but not just in terms of fees, Johnson says. "There are also opportunity costs, because the more you narrow a portfolio, the more stocks you leave out, the likelier you are to be missing out on the best-performing names," he says, citing the recently addition of Tesla to the S&P 500 as a prime example of a missed opportunity for investors in that index. "Total stock index funds had owned Tesla since shortly after its IPO."
Conduct a search for "total stock market funds" and you're likely to get a slew of results. Multiple brokerages and fund firms offer versions of the same basic fund, and luckily for investors, it's hard to go totally wrong if you choose any of them.
"These funds are going to be nearly identical, because they're market-cap weighted. Bigger companies like Apple and Microsoft make up much more of the portfolio than than smaller companies within the broader index," says Todd Rosenbluth, senior director of ETF and mutual fund research at CFRA. "One fund may hold 5,000 stocks and another 2,500. It sounds like 'double' — but it's not really much of a difference."
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The other piece of good news for investors: A decades-long price war between fund issuers means that investors can access firms' most popular index funds with little to no fees. Total market funds offered by Vanguard and Schwab, for instance, come with an annual expense ratio of just 0.03%. Fidelity customers can access the company's proprietary total stock market fund, which has no expense ratio.
"It's like pulling up to an intersection with two gas stations kitty corner," Rosenbluth says. "Both are selling something that will make your portfolio go. But you may drive across to the one that charges a penny less."
Once you have your core fund in place, you can add some portfolio diversification by investing in at least two to three more funds tracking different benchmarks. Start by adding exposure to international stocks. Broad international stock index funds, such as Vanguard's Total International Stock Index fund, can act as a compliment to your U.S. index holding, creating a portfolio that's invested in companies the world over.
"You could use those two and allocate how U.S.-centric you want your portfolio to be," says Rosenbluth. "That's an easy way to tilt your portfolio using ETFs." Currently, U.S. stocks make up a little less than 60% of the global market cap — so a roughly 60/40 split between U.S. and international stocks would put you just about in line with the global stock market.
If your time horizon and risk tolerance are such that you might consider holding an allocation to bonds in your portfolio, Johnson suggests adding an ETF that tracks a broad bond benchmark, such as the iShares Core U.S. Aggregate Bond ETF.
"Those three types of funds, for a lot of investors, can form a perfectly suitable portfolio," says Johnson. "It's like a simple, three-ingredient cocktail that you can pour into your shaker, mix the portions you want, and at the end of the day it will do quite well for you."
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From there, you'll have to keep an eye on your mix, lest any of the ingredients overpower the drink. "Any portfolio that you buy and hold over the long term is going to drift," says Rosenbluth. "If you owned U.S. and international equity over the last few years, you'd now have much more U.S. than international exposure." Setting your portfolio to automatically rebalance, or trimming your better-performing holdings to bolster your investment in lagging ones on a regular basis can keep things in line, he says.
And if the prospect of owning a few, staid funds sounds boring, experts say you can use ETFs that invest in more exciting areas of the market to spice things up. "There's no harm in carving out a small portion of your portfolio to invest in an area you're interested in," says Cliff Hodge, chief investment officer for Cornerstone Wealth. "Investing is serious business, but in order to keep your attention and to stick with it, you've got to have some fun."
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