So You Want to Invest: Index Mania

Yesterday, we covered just about the simplest method for investing you could have, putting your money into target date funds. But it’s a fairly hands off investment; used properly, you’ll hold the target date fund (and only the target date fund) until you reach your target date. What if you, like our fictional investor Becky, want something a little more involved?

“While I like the idea of a target date fund, it’s not quite for me. I need to be able to control my investments, and target date funds just don’t let me do that. Plus, I don’t like the particular arrangement of investments offered in the target-date funds I’ve seen. Where do I go for something that isn’t too complex, but gives me more control?”

Well, if you are trying to be more involved with your investments, but don’t want to do a lot of ‘stat-tending’* to make sure your investments keep doing well, there’s one phrase you need to remember:

Index Funds

Index funds are inexpensive, well-diversified, and passive.  Since they are designed to hold absolutely every stock, bond or other investment in a particular index (or a highly representative sample, at least), there’s no worry that you will do better or worse than that index.  You can decide on your allocation, buy the index funds and sit back until it’s time to change your allocation.

If you want a guide to how to use index funds to build an investment portfolio, well, you’ve come to right place.  Here’s a simple, but still pretty effective, way to invest for retirement with index funds:

1) When you have a long period of time (over twenty years) before you’re ready to retire, you’re going to want your investments to entirely in stocks or other growth investments.  Stock mutual funds should be split between domestic and foreign funds, although the ratio will vary depending on who you ask.  Something like 60% Total US Stock Market and 40% Total Foreign Stock should work for most people, although shifting 10% either way wouldn’t hurt.

2) With twenty years to go, you should start adding bonds to your portfolio.  Switch 10% of your portfolio over to a Total Bond Market fund (keeping the proportions of the stocks in the rest of your portfolio the same).  Every five years, at fifteen years to go and ten years to go, add an additional 10% bonds to your portfolio, so with ten years to go, you’ll have 30% bonds, 42% US stocks, and 28% foreign stocks.

3) At five years to go, add 10% cash (in the form of a money market fund) to the portfolio, taking from the stock portion of the portfolio, giving you a final portfolio of 10% cash, 30% bonds, 36% US stocks and 24% foreign stocks.  Not a bad portfolio to take into retirement.

Once again, this is just one possible way to use index funds to build your portfolio; even if you rely on just these few funds, there are numerous other progressions you could follow, with varying advantages and disadvantages.

Additional Types of Funds

As mentioned, this investment plan only uses a few types of different funds.  There are other types of mutual funds, of course, even amongst index funds.  (Depending on what mutual fund company you are investing through, you might need to opt for an actively managed fund or switch to a different fund company entirely to get all the types of funds listed below.)  Here are five to keep in mind as you are building your portfolio:

-Extended Market: Way back when, I wrote about the Pareto problem, where a fund that covers a total market will be over-weighted in the biggest companies.  You can avoid this problem by switching some of your US market holdings to an extended market fund, which will help to diversify your holdings more properly.

-Emerging Market: Pareto again; a total foreign fund will be weighed more towards developed countries.  Getting a separate fund that invests entirely in the emerging market will help to make your foreign holdings more balanced.

-(Small) Value Funds: In that same long ago post, I shared my belief that value-oriented funds will turn out to be a better investment in the long run.  Small value funds in particular will tend to outperform in the future, and are worth adding to your portfolio.

-Foreign Bonds: On the bond side of the equation, you could consider adding some foreign bonds to your holdings.  Diversification is usually a good thing, and doing so in your bond holdings is a good thing.

-Treasury Inflation Protected Securities (TIPS): One good way to protect against inflation is with a relatively recent offering from the US government, Treasury bills that adjust to compensate for inflation.  Switching some of your bond holdings to a TIPS fund will enable you to hedge against a great increase in inflation.

-Tax-Exempt Bond/Money Market Funds: Municipal bonds and money market funds are exempt from federal income taxes (and usually state and local taxes, if purchased by someone within the issuing states).  If you are in a high income tax bracket, keeping some of your bond and money market investments in tax-exempt holdings (for the investments outside of retirement accounts, of course) can reduce how much is taken in taxes.

Alright, that’s enough of how to build your own portfolio from index funds; if you want even more control over your investments, you’ll have to tune in tomorrow, when we’ll cover some more advanced investments.

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