A mutual fund invests pooled money from people or companies based on specific goals.  In this context, a fund buys stocks, bonds, or other investments.  Funds can be categorized by the types of investments being made – e.g. technology stocks, small cap, value, dividend producers, real estate, etc.  Because of the professional management involved, mutual funds do charge a management fee annually.  However, it is still much cheaper than trying to buy a basket of stocks.

A stock market index attempts to measure a section of the stock market universe.  The most well-known being the Dow Jones Industrials (30 largest stocks)  and Standard and Poor 500, or S&P 500 (top 500 US stocks by market capitalization).  There are many indexes that track various industries, capitalizations and other sections of the market.

Index funds attempt to mimic the behavior of stocks of a particular index.  There is no analysis or decision making that is required, just rebalancing of the portfolio.  This means fewer trades and fewer capital gains – ultimately the cost is substantially lower.  Over time, these costs savings can be significant.

Why Index Funds are a Great Choice

We love index funds for most investors.  Let’s look at some of the reasons why:

1. Costs – the management fees on index are substantially lower than actively managed funds.  Over a 10-30 year time horizon, that can mean tens of thousands of dollars.
2. Tax Advantaged – since index funds are not actively managed, there are fewer trades and thus, fewer capital gains being passed on to you.
3. Performance- it is a proven fact that the majority (75%+) of actively managed fund underperform index funds.  Sure, you might select the fund that happens to beat the index - but why even bother to fight the odds?
4. Your Time – researching investments, specifically stocks and mutual funds, requires time and understanding.  Investing in index funds is much faster.

It is obviously possible to get a better return through stocks and mutual funds (in fact, we cover those as well!), but be prepared to spend ample time learning and researching.  After all that, you still might have worse performance than an index fund, plus a lot more tax work on your Schedule D!

For the majority of people, we feel index funds are the best way to invest.  You can capture the whole investment universe, limit risk and downside, and save tons of your own personal time as well.

Which Index Funds to Buy

Index funds are diversified within their sectors but for consistent returns and moderate risk, you need to diversify broadly.  This is often referred to as asset allocation.

There are many different asset allocation models.  For the purposes of this post, we want to keep it simple.   Our sample portfolios utilize Vanguard index funds – they are usually the lowest cost industrywide, with low minimums.  Other financial institutions offer simliar index funds, so Vanguard is not your only choice.

Basic Asset Allocation Index Portfolio – Vanguard

• Total Stock Market Index (45%)
• Total International Stock Index (30%)
• Total Bond Market Index (20%)
• REIT Index (5%)

Advanced Asset Allocation Portfolio – Vanguard

• S&P 500 Index (15%)
• Value Index (10%)
• Small-Cap Index (10%)
• Small-Cap Value Index (10%)
• Pacific Stock Index (10%)
• European Stock Index (10%)
• Emerging Markets Stock Index (10%)
• Short Term Bond Index (10%)
• Total Bond Market Index (10%)
• REIT Index (5%)

Because of recent economic events, you may also consider adding precious metals and inflation protect securities to your portfolios.  Vanguard offers two actively managed funds:  Inflation Protected Securities Fund and the Precious Metals and Mining Fund.  Invest no more than 10% of your total portfolio in these.

Maintenance of Your Index Fund Portfolio

Each year, you should examine if your portfolio is still balanced in the percentages we originally outlined.  For example, your international funds may have had a great year and now account for 40% of your total portfolio value.  The act of buying and selling shares to the original weightings is called rebalancing.

Rebalancing is simple.  For funds that exceed our target portfolio percentage, sell shares and transfer them to the funds that are below the target allocations.  Most brokers make this very easy to do online.  To limit your tax exposure, you should sell shares that have increased in value at least one year after the purchase date (long term gains are taxed lower).

Summary

Index funds are an excellent investment vehicle for both beginners and seasoned investors alike.  The perform better than the majority of other investments and require very little maintenance over time.  And as the saying goes, “Time is Money”.  Happy Investing!