Index Investing (Index Funds & ETFs) Strategy Review

This guide will cover the major goals, investment selection methods, strengths, weaknesses, risks, long-term outlook, and investor profile for Index Investing.


Major Goals

Remember that we said Value Investing is our 2nd favorite strategy?  Well, this is our favorite. Index Investors are able to beat 80% of professional fund managers and analysts and an even higher percentage of individual investors with a simple and low maintenance strategy.

While most of us buy bits and pieces of the major indexes when we buy stocks or mutual funds, Index Investors want to own the whole thing.  How can they own a piece of every stock on a broad index such as the S&P; 500? The investing vehicles they use are called Index Funds and Exchange Traded Funds (ETFs), and when they buy shares in either type of investment they own a small piece of every stock or bond an index tracks.

One of the critical components of this strategy is the diversification and allocation mix.  This provides a lot of flexibility, Index Investors can be aggressive, conservative, or balanced investors depending on the mix of indexes they choose.  Because it is so important to maintain their target diversification and allocation mix, most index investors stick to the broader indexes.

Index Investors want to have a professional-grade portfolio that is cost-efficient and tax-efficient.  Can you imagine if you tried to buy stock in every company on the S&P 500?  Even if you had the hundreds of thousands of dollars required the transaction costs would eat most of your returns.  Before Index Funds and ETFs (which wasn’t that long ago), this strategy was only an option for very wealthy individuals or large corporations.  Index Investors only need to own between 10 and 15 of the best Index Funds or ETFs and they buy and hold for long periods of time.  Index Investing is the most cost-efficient and tax-efficient portfolio you can own since it is a buy-and-hold strategy that requires very few transactions.

Investment Selection Methods

Before an Index Investor even worries about what Index Funds or ETFs to buy, they determine what diversification and allocation mix best suit their investing style, goals, and risk tolerance.  Rather than discuss all of the factors that go into determining the proper mix, we thought it would be easier to give you three examples.

Profile: Aggressive Index Investors are a long way from retirement and usually feel bullish about the market. They are looking for capital growth because their portfolios are usually still relatively small (by “relatively small” we mean not nearly large enough yet to support 30 years of retirement). They have a high-risk tolerance and don’t mind market volatility. They know they can weather any short-term market corrections or even recessions because they have a very long investing timeline (at least 15 years to retirement, usually more). The chart below shows a typical Aggressive Index Investing portfolio.


Profile: Balanced Index Investors are mid-career and usually feel optimistic about the market but want to avoid extreme volatility. They are looking for capital growth but would also like to have a large chunk of their portfolio in the biggest and safest stocks that can dampen volatility and pay generous dividends. They tend to want some money in bonds for safe but modest returns and to offset the risk of their stock holdings. While they still need growth, they also want protection against market volatility and losses so that they can retire in 10 to 15 years. The chart below shows a typical Balanced Index Investing portfolio.


Profile: Conservative Index Investors are retired, near retirement, or feel very bearish towards stocks. They have very low-risk tolerance and want to avoid volatility and losses. They are often focused on dividends and bond coupon payments since both provide current income during retirement. Many are withdrawing more than they contribute to their portfolios. Since this is a big part of their income they want a lot of protection against market volatility and losses because the portfolio needs to last for the rest of their retirement. The chart below shows a typical Conservative Index Investing portfolio.


After they determine their asset allocation and diversification mix, Index Investors select Index Funds and ETFs much the same way a Growth Investor would.  They have a set of criteria, albeit more specific, that an Index Fund or ETF must meet before they will consider adding it to their portfolio.  Since Index Investing doesn’t require a lot of technical analysis or fundamental analysis, you can actually use the screening and data mining tools available at several of the high-quality investment research sites to find potential Index Funds and ETFs.  The example below shows a Morningstar Premium Fund screen that an Index Investor might set up to pull Index Funds that meet their Large Cap Value criteria.



Index Funds are subject to all the same expenses associated with traditional funds.  Index Investors need to run every fund through a Mutual Fund Checklist before they buy to avoid unnecessary Loads12b-1 Feestransaction fees, and redemption fees.  ETFs, on the other hand, never charge loads or fees because they trade just like a stock, but you will have to pay your brokerage’s transaction fees.  Transaction expenses shouldn’t be a problem as long Index Investors stick to their low-transaction buy-and-hold strategy.

Unlike Stocks and Bonds, funds have an expense ratio.  Since Index Funds and ETFs only require passive management, their expense ratio should be very small but it’s still important to keep track of because it comes straight out of your returns.  For example, if an Index Fund has an expense ratio of 1.5% you can go ahead and reduce your annual gain from that fund by the same amount.

So if a fund has a lot of expenses, and these expenses come right out of returns, how will it be able to track it’s index accurately?  Well… it won’t.  In fact, it will lag behind its index badly if it has a lot of expenses.  Do your homework before you buy, look at the 5-year performance and make sure that your fund isn’t lagging the index badly as a result of too many expenses or inaccurate daily rebalancing.

Because Index Investors have a variety of assets and stock types in their portfolio, some pieces will grow faster than others.  This will throw the allocation and diversification off which means the portfolio is no longer optimized.  To correct, Index Investors have to rebalance occasionally.  Many index investors make it a habit to rebalance once per year to ensure that they stay in their investing sweet spot.


Index Investing is easy to learn, it’s ideal for beginners, and it will beat most professional investors.  There is no other strategy that is easy to master and that will also beat most investors’ returns.

Index Investors plan out their allocation and diversification mix before they buy their first fund, this creates a very well-balanced professional-grade portfolio.  Why is this so important?  If you master asset allocation and diversification, you can lower risk AND improve returns at the same time… that’s a pretty good combination.

Index Investing is a passive strategy, your portfolio will be very low maintenance once you get your allocation and diversification mix properly set up.  Index investors don’t need to perform constant analysis or even stay abreast of market and economic trends, they just need to check in now and then to make sure their funds are still expense-efficienttax-efficient, and closely tracking their indexes.  They will also review their allocation and diversification mix now and then to make sure it still matches their investment goals and risk tolerance.

This is a very well-balanced approach to investing.  Some parts of your portfolio will always be doing well regardless of market conditions.  Confusing?  Two things are working in your favor.  One, not all asset classes move up and down at the same time.  For example, bonds do well when interest rates are going down.  If there is a market correction or recession, the Federal Reserve Bank (commonly referred to as the Fed) will inevitably lower rates to jump-start the economy so whatever portion of your portfolio resides in bonds will do well even though your stocks are going down.  Two, some of your investments will be more volatile than others.  For example, Small Caps may go from big gains one year to big losses the next but Blue Chips may perform well for you in both years.  Even though the potential returns of your Blue Chip investments are smaller than the more volatile small-caps, they help to limit losses and balance your portfolio.

Long-Term Outlook

Index Investing is already getting big and the popularity will continue to grow because there is so much working in this strategy’s favor.  Performance holds up well when compared to other strategies regardless of market conditions, you won’t find a better-balanced approach to investing.  This is also the most cost-efficient and tax-efficient strategy available, it’s hard for other strategies to measure up, especially if you’re investing in a taxable account.

Investor Profile
Index investing is a balanced approach in more ways than one, this strategy can accommodate aggressive investorsconservative investors, and balanced investors.  There is an asset allocation for any investing goal and risk tolerance.  However, that doesn’t mean this strategy is a good fit for everyone.  There are two types of traders that will have disastrous results with this strategy.

Traders that constantly try to move out of “Bad” index funds will take big losses.  Index Funds and ETFs just track their index, their performance is never “Good” or “Bad”.  Rather than maintaining their asset allocation and diversification mix, this type of trader will constantly chase returns by trying to move to indexes that are currently performing well.  If they are trying to invest only in index funds and ETFs that are going up they are NOT an Index Investor, but this behavior is a great way to lose money fast if they’re looking for a tax write-off. Trust us, if you are properly allocated and fully diversified, just ride it out.

The other type of investor that will fail miserably at this strategy is the frequent trader.  Some investors just can’t handle doing only 5 to 10 trades per year, they HAVE to trade so they are constantly tweaking their portfolio by switching to different index funds and ETFs.  This will increase their transaction costs, create a tax liability, and screw up their asset allocation and diversification mix.  This behavior pretty much neutralizes all the benefits associated with Index Investing.

So what type of person masters this strategy quickly?  Oddly, a person who places great value on their personal time, someone who doesn’t want to become a professional investor or spend a lot of time managing their portfolio.  However, this person must also be willing to study hard at first to learn the strategy.  They must fully understand index investingasset allocationdiversificationexpense managementtax management, and all of the criteria involved in identifying top-notch funds.  This is a steep learning curve at first because there is so much information, but when you reach the peak, your portfolio goes into cruise control.  You will only need to check in occasionally, you can spend your spare time on the golf course, playing video games or with your family.

Want to learn more about Index Investing?

If you’re a do-it-yourselfer, read our Complete Guide to Index Investing.  Our guide will teach you everything you need to know about ETFs and Index Funds. You will learn how to put together a well-diversified and properly allocated portfolio that matches your investment goals and risk tolerance.

Rather find an advisory service that provides model portfolios and buy/sell recommendations?
Half of the Fund Street monthly advisory newsletter is dedicated to Index Investing. We track three different Index Portfolios; one for the Aggressive Investor, one for the Balanced Investor, and one for the Conservative Investor. We show you which funds to own, when to buy, when to sell, and what percentage to allocate to each in your portfolio. There is also a lot of monthly commentaries related to index investing to help you stay in tune with the market and economic conditions around the world that will impact your portfolio. Best of all, Fund Street’s 100% guaranteed service is only $149 per year so it won’t blow your expense budget out of the water.

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