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Complete Guide to Index Investing (Index Funds and ETFs)

Michaels Drois

May 6, 2020

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 Welcome to our Complete Guide to Index Investing! We’ll teach you how to find the best Index Funds and ETFs available, then we’ll show you how to build a properly allocated and diversified portfolio that matches your risk tolerance and investing goals. 

Index Fund and ETF Investing Guide

If you followed our guides all the way through to this article, you’re ready to learn your first investing strategy, congratulations!  You’ve learned about the Stock Market, Stock Basics, Mutual Fund Basics, Tax-Deferred Investing (401Ks, IRAs & Roth IRAs), and The 10 Basic Principles of Investing.  You may still feel like a newbie but you actually have a solid base of investing knowledge and you’re ready to learn some strategy.  This section will introduce you to what we feel is, without a doubt, the best strategy for beginning investors, Index Investing.

Indexes Revisited

We explained what market indexes are in previous guides but they’re so important to this strategy that we wanted to throw in a couple of refresher paragraphs.  Remember that an Index combines together a group of stocks that have something in common and tracks their combined performance?  Since we’ve used the S&P; 500 for most examples, you may not have realized that an index can be broad and encompass large numbers of stocks (like the S&P 500) or can be narrowly focused and comprised of only a few stocks such as the Metabolic-Endocrine Disorders Index Fund.  We could be wrong, Metabolic-Endocrine Disorders might be the next Microsoft but somehow we doubt it, take our advice and stick to broader indexes.

You may also remember that indexes were tied into Investing Principle #5, Compare to an Appropriate Benchmark.  This is important because if you measure your portfolio against an index that contains similar stocks, you’ll know exactly how well or poorly you are choosing investments.  However, what we will focus on in this guide is buying the entire index rather than just bits and pieces.  Thanks to the relatively recent creation of ETFs and Index Funds you can own a share of the S&P 500 or any other index for as little as $50.  I’m sure you’re wondering why anyone would want to do that, right?  Let’s answer that question first.

What makes Index Investing such a great strategy?

Usually, we would wait until the end to analyze the strengths and weaknesses of a strategy but since we think so highly of this one we want to emphasize early in the guide that this strategy is a winner.  Hopefully, that will keep you from breezing through to the end only to find that you wished you’d read more carefully.

Did you notice that in the title of this section that we stopped saying Index Investing is a great strategy for beginners, we were content to simply say it’s a great strategy?  Index Investing is ideal for beginners due to its simplicity but it is also a powerful enough strategy to easily beat 80% of professional money managers and analysts and a much higher percentage of ordinary investors.  Regardless of your strategy, if you’re beating this high a percentage of all investors, stick with it, you have a winner.

You can buy into an index either through an Index Fund or through an Exchange Traded Fund (ETF).  When you buy either type of fund you are basically accepting the returns of the market.  While that doesn’t sound very exciting, remember that 4 out of 5 Ivy League MBA toting Fund Managers aren’t able to do better.  We will even go one step further and say that if you master this strategy, you will actually beat the market.  How can you beat the market when you’re buying investments that track the market?  We’ll explain that in detail later in this guide, for now, you just need to know that it is possible and that it is accomplished through diversifying your portfolio between different indexes and asset types.

Another huge advantage of this strategy is the built-in diversity.  Because you are buying an index of stocks you know that your investment is spread over a wide range of industries, categories, and geographies.  Remember what you learned about diversification in the 10 Basic Principles of Investing Guide?  If you diversify properly, you lower risk AND improve returns at the same time because you are optimizing risk Vs returns.  As long as you also consider diversification and asset allocation as you build your Index portfolio, and we’ll show you how later in this guide, you will always find this investing sweet spot.

Index investing is an affordable way to have a professional-grade portfolio with a very small investment.  Can you imagine if you tried to buy a piece of every company in the S&P 500?  Even if you had the hundreds of thousands of dollars required, the transaction costs would eat a lot 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 investing is a great opportunity for the average investor who wouldn’t otherwise have the opportunity to build such a broad portfolio.  By buying into an Index fund you can get a small piece of every company that the index tracks for the cost of a single share.

Most important to beginners, this is an easy strategy to learn and implement.  The rest of the guide is dedicated to teaching 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.  What do you do after you have your portfolio set up?  Go play golf, read, play video games, or spend time with the family.  This is a passive strategy and is therefore very low maintenance.

Keys to Successful Index Investing

Ready to talk strategy?  You’ve read a book worth of guides to get here so more than likely you’re VERY ready and excited to start investing.  This is the most important section of the guide– we’re about to put together the final pieces of the Index Investing puzzle.  None of the remaining material is complicated but there is a lot of information.  Pace yourself, take in one section at a time and don’t move to the next until you’ve fully grasped each concept.

This guide was written with Basic Investing Principle #10 in mind, we always try to Keep it Simple.  If a section seems difficult it’s probably because you didn’t fully understand the previous one.  Any confusion will most likely be a result of the overwhelming amount of new information being thrown at you, NOT because investing is too complex or sophisticated for you.  Go back and reread until you’re comfortable.

Since we have a lot to cover we’re going to divide it into several categories.  This should make it a little easier to digest and will provide good places to take breaks when your brain gets full.  The strategy sections are: “How Does it Work?”, “Nuts & Bolts”, “Asset Allocation and Diversification”, “Choosing your Indexes”, and “Tracking your Performance”.

How does it work?

Let’s get started…

There are two ways to build an Index portfolio, through Index Funds or through Exchange Traded Funds.  More than likely you will always have a blend, but transaction costs will be a major factor in deciding between the two.  Since most beginners have smaller portfolios (less than $100K), you will tend to have many Index Funds when starting out.  However, over time you will likely shift more money into ETFs because transaction costs will have a smaller and smaller impact on returns as your portfolio gets larger and also because ETFs offer many advantages over even the best Index Funds.

You are not limited to the S&P 500

Most investors associate Index Funds and ETFs to major indices like the S&P 500 because those funds are so large and popular, however, both Index Funds and ETFs offer a wide variety of indexes.  You can find a coinciding index for just about any type of stock, industry, geographic region, or strategy that you’d like to try.  In fact, each category will probably offer several different funds for the same index.

Does it matter which one you pick if you’re trying to decide between several funds that track the same index?  You bet it does.  Just because they all track the same index doesn’t mean they are the same.  Each can have a different fee structure, purchase requirements, expense ratio, and redemption period to name a few and each of these factors has tax implications and will impact your returns.

How Index Investors Benefit from Passive Management

One of the greatest advantages of Index Funds and ETFs is that they are all passively managed.  That means that they don’t require the Harvard MBA and a team of analysts.  All that is required is daily rebalancing so that the fund’s holdings still match up with that of the index.  A nice byproduct of this is that it removes the human element from management, the strategy is completely objective and straightforward, Index Funds and ETFs just track their index.

Another great side effect of passive management is that it makes Index investing an extremely cost-efficient strategy.  It enables Index Funds and ETFs to have very low administrative fees and expenses.  Index trading requires very few trades, it’s a buy-and-hold strategy so stock traders and traditional mutual fund traders will almost always carry more expenses than index traders.  Stock traders are typically higher because they make frequent trades which increases transaction expenses and tax liability.  Traditional mutual funds carry higher costs because they have to pay a fund manager and his team of analysts so expense ratios are much higher.  Very few strategies can compete with ETFs and Index Funds in terms of cost-efficiency.

Index Investing Minimize Capital Gains Distributions

Since index funds and ETFs are usually only replacing stocks that are losing money, their capital gains and distributions are very small.  Huh?  Yeah, it’s a little confusing but this gives Index Funds and ETFs a big advantage over traditional funds so read the next paragraph carefully, it will save you a lot of money.

Because most traditional funds trade a lot they are constantly passing capital gains distributions on to shareholders and this can have serious tax consequences.  Because ETFs and Index Funds track indexes, they always hold the exact same stocks as the index.  Many of the broader indexes, such as the S&P 500, track the largest and most successful companies in America.  How do you get booted from the S&P 500?  If a company performs poorly and their market capitalization decreases (a fancy way to say the stock price drops) dramatically, they will be replaced.  How does this create an advantage?  If a stock’s price is dropping it is losing money.  If you’re only selling off the stocks that are losing money, there is no capital gain to pass on to investors.

The only capital gains that you’re going to have to deal with on a regular basis as an index trader are dividends.  They are taxable, and they are unavoidable if you’re trading stocks and funds.  However, don’t let that make you think that dividends are a bad thing.  Even though a company is creating a tax liability when they pass you part of their profits, dividends also boost your returns.

Index performance is never “good” or “bad”

One of the more confusing aspects that ETFs and Index Fund have in common is that their performance is never “good” or “bad”.  When you’re evaluating a regular fund, stock, or bond, you are always trying to find investments that you think will outperform over time.  Most stock, traditional fund and bond choosing strategies are performance-driven strategies, the goal is to find investments that will outperform the market.  Index Funds and ETFs never attempt to outperform anything, they simply track their index regardless of whether it is going up or down.

Why does this matter?  Two reasons.  First, you want to avoid jumping between different indexes just because some are doing “bad”.  If you are trying to invest only in index funds and ETFs that are going up you are NOT an Index Investor, but this behavior is a great way to lose money fast if you’re looking for a tax write-off.  Trust us, if you are properly allocated and fully diversified, just ride it out.  Second, don’t assume just because your Blue Chip Index is doing “Bad” means that you own a bad investment.  It only means that Blue Chips aren’t doing particularly well right now, but you should still hold on to the fund if Blue Chips are an important part of your allocation mix.

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Nuts and Bolts

Decisions, decisions
This section is particularly important because it will tell you which of the two types of funds best suits your current portfolio and investing style.  We already stated that ETFs have many advantages over Index Funds but read this section carefully before deciding which you prefer, especially if your portfolio is still less than $100,000.

How do I buy Index Funds and ETFs?
Index funds can be brought through the exchange (meaning you can buy them through your online brokerage) or directly from the fund family, but ETFs can only be bought through the exchange.  ETFs are different because they trade like stocks, you can buy and sell them whenever the market is open.  Index funds are more similar to traditional funds, you can only purchase once per day and your transaction is settled at the end of the business day.

You can also buy Index Funds direct from the fund family but there are drawbacks.  If you buy direct from various fund families you will have multiple portfolios to keep track of.  Since your money is in several places, you will also lose out on the powerful portfolio management and analysis tools available at the major online brokerage sites.  Plus, if you decide you don’t like a fund family you’ll have to wait several days for them to settle, cut a check and send you the cash, which leaves your money on the sidelines while you wait.  We recommend that beginners avoid buying directly from the fund, there is no reason to put up with these headaches when there are so many inexpensive Index Funds and ETFs available through the major online brokerages.

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Avoid Fees
Unfortunately index funds are similar to traditional funds in more than just the way the transaction occurs, you will have to go through the full Mutual Fund Checklist to make sure you don’t get hit with fees and loads.  You should never pay any Loads, Redemption Fees, 12b-1 Fees, or Transaction Fees, and luckily most funds (especially the good ones) don’t charge them.  Also check to see that the expense ratio is in line with or lower than ETFs that track the same index.  If you need a refresher on all of these fees go directly to the Mutual Fund Checklist or browse the entire Mutual Fund Basics Guide.

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Expense Ratios
When you begin evaluating different funds you’ll notice that Index Funds have higher expense ratios than ETFs.  Traditional funds and Index funds have to negotiate with online brokerage houses to get listed in investment databases.  Rather than paying these fees, they pass the expense on to investors which increases the expense ratio of the fund.  Typically Index funds add between 0.15% and 0.35% to their expense ratio as a result of this expense.  ETFs are treated differently, they aren’t charged anything since they trade on the exchange like any other stock.  This makes it very hard for Index Funds to have expense ratios as low as ETFs.  This doesn’t mean that all Index Funds have higher expense ratios than ETFs, just that they tend to, unless they are very large.

There is no magic formula since different categories and geographies will vary but we can provide some loose expense ratio guidelines to follow.  For the major and broadest US indexes, such as the S&P 500, you should try to avoid anything with an expense ratio greater than 0.35%.  For smaller or narrower US indexes such as Large Cap Value, you may consider going as high as 0.70% depending on how strongly you feel about the category.  Foreign funds are usually more expensive because the indexes they track are more fluid and may require complex transactions on multiple exchanges.  Since they are a little trickier to manage you should consider expense ratios up to 0.99% for most foreign funds.

Please remember that these are just loose guidelines.  The fund’s expenses come right out of your return which is why they’re so important to consider whenever you’re about to buy.  That being said, if we were comparing several funds that track the same index, we wouldn’t always recommend that you buy the lowest expense ratio.  There are many other factors to consider, such as transaction fees and loads, which play just as big a factor in overall cost efficiency.  The key is to remember that the expense ratio and all other expenses come right out of your profits so you have to choose an index fund or ETF with strong enough returns to make up for whatever expenses they charge.

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ETFs Are Sold in Lots like a Stock
One tax advantage that ETFs have over Index Funds is that you can sell the ETFs with the highest cost basis first since they are sold in lots like a stock rather than at the average NAV price.  Want to hear that again in English?  For example, let’s say you bought 100 shares of an ETF at $30 and later you buy another 100 shares at $40 and the index is currently trading at $35.  If you decide you want to sell 100 shares to buy a different index, you can choose which lot to sell.  Obviously you want to choose the $40 lot because that creates a capital loss (a tax save) rather than selling the $30 lot which would create a capital gain (a tax liability).

So which are better, Index Funds or ETFs?  It depends…
Have you decided which you like better?  You’re probably leaning towards ETFs since they offer a lot of advantages over index funds but don’t forget about transaction costs.  The average trade is going to cost around $10 so every time you buy and sell an ETF you’re going to spend $20.  There are no transaction fees for many Index Funds, they trade for free through your online brokerage and then the fund passes the expense back to you in the expense ratio.  So the question is which is more expensive, the transaction fees or the increase to the expense ratio?  Let’s look at an example.

Example:  Which do I choose, Index Fund or ETF? 
You have a $50,000 portfolio and you made 20 trades this year.  Your portfolio gained 20% so your profit before we factor out expenses is $10,000.

If you trade ETFs, you spend an average of $10 per trade.  Transactions cost you $200 (10 buys and 10 sells at $10 each = $200) so your total profit is $9,800. 

If you are an Index Fund trader you don’t have to pay any transaction costs but your expense ratio is 0.35% higher.  This means the higher expense ratio cost you $35 (0.35% X $10,000 = $35.00) so total profit is $9,965. 

So our answer is that it depends on the size of your portfolio and how frequently you trade.  Index Investors have very few transactions, but if you are dollar cost averaging (and you should be) you will be investing additional money on a regular basis and would rack up a lot of transaction fees in ETFs.  The situation changes when your portfolio exceeds $100,000.  It becomes very difficult for Index Funds to compete with ETFs because the transaction fees become pretty negligible.  Why?  Because you can hold money in a savings or money market account until you have a sizeable chunk to invest without messing up your asset allocation when you have a larger portfolio.

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Track and Manage Expenses
Tracking and managing expenses is important because every penny that you spend reduces your profit by the same amount.  Even though expense management is not specific to Index Investing, it is important enough to include in this guide because it is a critical component of EVERY successful strategy.  This is especially true for beginning investors.  Why?  Expenses tend to get away from beginners very quickly because they don’t have much experience tracking investing costs and because many feel they need to pay for a lot of investing help.

If you want to get off to a good start, set a limit for your spending and do your best to adhere to it throughout the year.  The most dangerous expenses to your profits are taxes, transaction costs, fees, and investing information expenses.  A good rule of thumb is to try to limit your realized gains to 15% or less to minimize tax liability and try not to exceed $600 combined for the remaining transaction costs, fees, and investing information expenses. In other words, your total investment expense should not exceed $600 + tax expense.  We’re only going to provide some summary information here to keep the size of the guide down, if you want more detailed expense management information go review Basic Investing Principle #4 – Manage Expenses.

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Investing Budget Example:  Let’s see how much we can do with an $600 investing expense budget + Tax expense on a $100,000 portfolio.  

TOTAL Annual Investing Expense Budget = $825
Transaction Costs:  $200
Fees:  $0
Taxes:  $225
Investing Information: $400

Transaction Costs Budget:  $200
Index Investing is a buy-and-hold strategy, you shouldn’t have many transactions per year.  However, we know that beginners will experiment with different allocations and try to figure out which fund is best for each Index so let’s assume an aggressive 20 trades per year.  Each trade equals one buy and one sell so this means 40 total transactions.  Hopefully we convinced you in the last section that investors with smaller portfolios should try to mix in some Index Funds rather than only buying ETFs since there are no transaction fees, the only expenses are the management and administrative fees in the Expense Ratio of the fund.  If at least half of your trades are Index Funds, you only had to pay for 10 ETF trades.  Since the average transaction is $9.99 and a trade equals one buy and one sell, you spent 20 X $9.99 = $199.80.

Many beginners that have only worked with brokers and financial planners are usually stumped at this point.  “How can my average transaction be only $9.99 or free in the case of Index Funds?”  A legitimate question considering brokers charge an average of $35 per trade and financial planners tend to charge even more and hide the expense in loads, commissions and other transaction fees.  To clarify, the average of $9.99 is for online brokerage houses, NOT your local broker or planner.  If you’re not familiar with online brokerages, read our Online Brokerage Guide before you continue.

Fees Budget:  $0
This section is simple, never pay any Loads, Redemption Fees, 12b-1 Fees, or Transaction Fees.  Its optional for Index Funds to charge them therefore it’s optional for you to pay them.  Don’t ever think that you’re missing out on the better Index Funds by refusing to pay extra fees, most funds no longer try to sneak fees in because they’ve learned that it puts them at a competitive disadvantage. Pay $0 fees.

If you’re trying to buy online and are having trouble figuring out if a fund charges any fees, go to our Online Investing Directory to get the toll free help number for your online brokerage.  Most have outstanding mutual fund attendants and the calls are free.  Unusual, right?  Just because you aren’t paying transaction fees doesn’t mean the brokerages aren’t making money, they charge the fund up to $90 for each trade so they have ample motivation to provide great service.  When you call, your mutual fund attendant will be able to tell you if there are any fees and they will also be happy to teach you to use their online tools so that you can check the fees the next time you buy.

Taxes Budget:  $225
Taxes are a large expense for those of us with portfolios in a taxable account.  Our first piece of advice is to stick every penny you can into tax deferred accounts (read our 401K, IRA and Roth IRA basics guide to learn more about tax deferred accounts).  This will allow your money to grow tax-free until you retire which will save you a fortune in tax expenses.

For those of us that can’t put all of our savings into tax-deferred accounts, index investing is an ideal strategy because you buy and hold for long periods of time.  This is the best way to keep your tax expense low.  Why?  If you hold an investment for at least one year before you sell, you only have to pay the long term capital gains tax on the profit which is 15% for most of us and 5% in the lowest tax brackets.  Warning!  If you don’t hold your investment for at least a year, you will pay your normal tax rate which can be as high as 35%.

Let’s look at an example so we can better explain how we came up with our $225 estimate:
Your $100,000 portfolio gained 10% for the year so total profit is $10,000.  You don’t have to pay a penny in taxes until you realize a profit, which means until you sell your Index Fund or ETF.  Next we assumed that because in any given year most beginners will make a few trades and receive dividends, you’re going to have to realize some percentage of your profits, 15% in this example.

Realized Gain:  $10,000 profit X 15% of profit is realized = $1,500 actual realized profits.
Tax:  You held for more than a year so you only owe 15% of your realized profits.  $1,500 realized profits X 15% tax bracket = $225 paid in taxes.

Is this example realistic?  It’s aggressive in our opinion.  You should be holding for as long as possible to realize even less than the 15% per year we used in the example, that’s the whole point of Index Investing.  Since you don’t have to worry about capital gains distributions as much as traditional fund traders would, your only real tax liability comes from your own behavior.  Long story short, buy and hold.

Investing Costs Budget:  $400
Our last category, investing costs, consists of the price you pay for whatever type of investing advice you buy each year.  It can consist of financial planning, web site subscriptions, monthly investing newsletters, investing classes, and magazines subscriptions to name a few.

We only have $400 left in our budget for these expenses and they are usually the first to skyrocket because smart beginners LOVE to buy investing information.  We agree that getting good information is important for new investors, but it doesn’t have to be expensive.  Let’s review several investor needs and affordable solutions.

Need – You want to keep up with the market and the economy, continue to learn, and get some personal finance advice to provide balance to your investing education.
Options –

1. A 12 month subscription to Smart Money published by the Wall Street Journal only costs $14.99 per year.  This magazine contains outstanding content similar to the journal with a little more emphasis on personal finance articles than the Journal.
2. Kiplinger’s Personal Finance costs $19.99 per year.  Despite the title, this magazine focuses on both the market and personal finance.  Great content plus a lot of educational material.
3. Money Magazine $14.99 per year.  This magazine contains a little something for everyone, you can always count on each issue to emphasize a different aspect of personal finance and investing. Like Money-and-Investingl.com, they shun the ivory tower mentality. Their publication is a fun and easy read and it always provide a lot of high quality educational content.

Solution – $14.99   We suggest Money Magazine for beginners.  It’s cheap, fun to read, and it contains tons of high quality personal finance and investing material.

Need – You want portfolio specific buy and sell recommendations from a proven market beater.  Your advisor should also provide continued education and in-depth market and fund analysis.
Options –
Investing Advisory services that provide specific buy/sell recommendations and model portfolios:

1. Fund Street $149 per year.  Proven market beater that provides a lot of market analysis and investment/personal finance tools.  Emphasis on long-term growth and Index/ETF funds.  Provides strategy, model portfolio and specific buy/sell recommendations.
2. Equity Fund Outlook for Mutual Funds $149 per year.  Edited by renowned fund expert Thurman Smith.  Emphasis split between tax-deferred and taxable accounts.  Provides strategy, model portfolio and specific buy/sell recommendations.
3. The Prudent Speculator for Stocks $195 per year.  Market beater for over 25 years.  This seasoned investing team is led by Al Frank’s protégé and successor, John Buckingham.  Emphasis on growth.  Provides strategy, model portfolio and specific buy/sell recommendations.

Solution – $149.99    We suggest Fund Street.  Not only is it a proven market beater, but also half of the newsletter is focused on your bread and butter, Index Investing.

Need – Financial Planning Advice
Options –
Financial Planners:  Generally they are worth the dollars spent if you need help with advanced estate, insurance, or tax planning.  Beginners will rarely need this type of service.
Solution – $0   Beginners don’t need this service yet.

Need – Training Classes, Workshops and Seminars
Options –
Investing education Classes:  Typical investment workshops, seminars and courses cost anywhere from $1,000 to $5,000 and we’ve yet to see any material that you couldn’t have gotten online for free or through a local bookstore for $20.  While we don’t think you’ll find a better resource than Money-and-Investing.com, there are many other similar sites that offer high quality free information on related topics.  Why pay thousands when there’s so much great free (internet) and inexpensive (bookstore) investing information available?
Solution – $0    Beginners, especially index investors, don’t need this service.

Need – You want to learn to do your own research and validate recommended Index Funds and ETFs.
Options –
You need to select a subscription to a site that will provide robust data and investing analysis tools.
Solution – $203.40 per year   We applaud the ambition beginners that are already thinking of taking this important step.    Hopefully you’d prefer to at least validate the recommendations you’re getting from your advisory services.  Since all investing research sites are different and can be tough for the newbie, we’re only going to recommend our favorite and most user-friendly, Morningstar.com.  They have a great variety of free investing tools, so check out the free stuff before you sign up for the paid service.  Even if you decide to buy, the subscription is only $16.95 per month and it includes exceptional tools for screening, researching, and selecting stocks and funds.  If you want to learn more, read our Morningstar.com, the Power of Institutional Investors at your Fingertips guide.

How did we do?
Transaction Costs = $199.80
Fees = $0
Taxes = $225
Total Investing Information Expense = $368.38
TOTAL ACTUAL EXPENSE = $793.18

Our annual budget was $825.00 and our total expenses are $793.18.  We are under budget, and you are still able to cover all of your transaction costs, taxes, and receive the best investing advice available!

A note on the last expense… We don’t recommend this approach, but if you don’t plan on doing much of your own research and analysis, don’t join a pay site like Morningstar.  In-depth research and analysis services are wasted on the casual investor that simply buys the Index Funds and ETFs that his advisory service recommends.  It’s dangerous to blindly trust any advisor or advisory service but if you plan to do so, you will only need to look up quotes, charts, financial results, news and other basic information.  Save yourself $200, your online brokerages will have all the tools the casual investor will ever need.

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Asset Allocation and Diversification
Asset Allocation (mixing together various asset types such as stocks, bonds, funds and cash) and diversification (spreading investments across categories, industries and geographies) go hand in hand and they are critical to every successful long-term investing strategy.  You have a big advantage as an Index Investor since you will plan your asset allocation and diversification mix before you even start building your portfolio.  It’s also easier to maintain since you won’t be trading much, most other strategies require frequent trades.  This makes it very difficult for them to maintain a healthy mix since allocation and diversification changes with every trade.

Remember when we said you can be an index investor and still beat the market?  That is due to proper diversification and asset allocation and here’s how it works.  You will compare each of your individual Index Funds and ETFs to a relevant index but you will also need some way to measure the performance of your entire portfolio.  More than likely you will pick one of the broadest indexes such as the S&P; 500 (500 biggest companies in the US) or the Wilshire 5000 (total US Market).  Through asset allocation you will be spread between stocks, bonds, funds and cash and through diversification you will have a good mix of large cap, mid cap, small cap, and foreign stocks.  This balanced approach is the best way to optimize risk Vs return.  By investing in this “sweet spot” you are able to increases returns and lower the risk of losses at the same time.  The result is that your overall portfolio returns will likely be higher than the market index you compare your overall portfolio against.

How does this work?  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 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 cap component of your portfolio, they help to limit losses in bearish markets.

Are you sold on the idea of proper asset allocation and diversification?  We hope so.  It’s time to design your portfolio.  Below are sample portfolios based on three major categories of risk tolerance and investing goals.

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Aggressive Asset Allocation
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).

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Balanced Asset Allocation
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 appreciation 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 for the loss protection that they provide against stocks.  While they still need growth, they also want protection against market volatility and losses so that they can retire in 10 to 15 years.

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Conservative Asset Allocation
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.

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Choosing Your Indexes
Did one of the sample portfolios suit your risk tolerance and investing goals?  If not, don’t worry, they are only guidelines, you can blend strategies together to come up with your own personalized mix.  If you design your own strategy, avoid putting over 45% in any one category or only splitting your portfolio between two or three categories, you will lose the benefits of asset allocation and diversification.

Most index investors eventually become familiar with most of the major indexes simply because it’s central to their strategy.  No rush, this will come with time, no need to try to memorize the chart below.  We are only providing it because it’s important to our next discussion.  You can refer back to this chart any time you forget what any of the major indexes track.  NOTE:  This isn’t even close to a complete list, just an alphabetically ordered list of some of the broadest and most popular indexes for reference.

If you plan on doing your own research, it’s essential that you have access to a powerful research and analysis site like Morningstar.com or you won’t have a way to search for Index Funds and ETFs that meet your criteria.  Some investors prefer to just buy and sell whatever their investment advisory services recommend but we strongly suggest that you at least learn how to validate their recommendations.

Since you are not a member of Morningstar.com you can’t use their premium research tools but don’t worry, you don’t need to sign up just yet.  We can still show you where the Index Fund and ETF screening tools are and explain how they work even if you’re not a member.

Click on the following link to go open a new window that will take you to the Mutual Fund section of Morningstar.com.  On the right-hand side of the screen halfway down the page you will see a box labeled “Premium Preset Screens”.   Within that list is a link called “Index Funds” and this is where you’ll go for Index Fund research and analysis if you eventually choose Morningstar.com as your investing web site.  However, please review several sites before you choose one, Morningstar is our favorite but you may find that some other site offers tools that better match your needs and preferences.

Now let’s walk through a step-by-step example of how you would identify some great Index Funds for your portfolio.  When you are a paying Morningstar subscriber and you click on the “Index Funds” you will be taken to the Premium Fund Screener.  The Premium Fund Screener is user-friendly even for the non-techie.  You can choose from hundreds of different Index Fund criteria in an easily navigable dropdown menu.  In fact, you can select index funds that meet any of the criteria we cover in this guide.

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Here’s a sample Premium Fund Screen for Index Funds: 
Let’s say that we want to identify Index Funds that can help us fill out the US Large Cap Value portion of our portfolio.  The box in the top left of the picture below that says “General” is the dropdown menu where you will select screen criteria. We select the following criteria from the dropdown menu in the Premium Fund Screener to create a list of potential Index Funds:

You will also want to add “Brokerage Availability” and then choose your brokerage from the dropdown list to make sure that you can actually purchase the Index Funds that pass your screening criteria.

If you’re curious how well this particular screen worked, it pulled 14 funds, most of which are good matches for many of our Large Cap Value criteria.  Our favorite on the list is the Vanguard Value Index.  The Expense Ratio is a low 0.2%, the minimum initial investment is only $3,000 and the NAV is only $24.  Fees are great too, the fund doesn’t have any loads, 12b-1 fees, or redemption fees and there are no transaction fees as long as your brokerage account is with Vanguard.com.  The icing on the cake is that the Vanguard Value Index (VIVAX) is actually beating the index it tracks year-to-date!  How?  They do futures trading to help cover the management and administrative fees.  They’re so good at it that their profits are exceeding the expense to manage the fund and the result is that their returns are better than the index.

The next tool we want to show you is Morningstar’s ETF Screener.  This is a very simple tool, there are only 8 dropdown menus from which to choose criteria.  Again, if you’re not a member, don’t worry, this step-by-step example will help you understand how the tool works and the instructions will work just fine later if you decide to sign up and use it.

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Here’s a sample ETF Screen:
Let’s say that we want to identify Index Funds that can help us fill out the International portion of our portfolio and we want to focus on emerging markets.  No problem, you only need to change two of the eight dropdowns to pull these ETFs, leave the rest alone.

Set Fund Group = International and set Morningstar Category = Diversified Emerging Mkts

This screen pulls 16 ETFs, most of which are good matches for many of our international fund criteria.  Our favorite on the list is the iShares MSCI Emerging Markets Index (EEM).  The expense ratio is only 0.74% which is good for a foreign fund this strong and diverse.  This MSCI Emerging Markets fund also acts as the index that many people follow and compare their foreign stocks against.  You get great diversity, the MSCI Emerging Market ETF contains a mix of large, medium, and small cap foreign stocks in 28 different countries.  Since ETFs trade like stocks, your only up-front expense is the cost of a stock transaction at your online brokerage, the average is about $9.99.

Alright, so now you can find Index Funds and ETFs that meet your investing criteria, congratulations, you’re almost ready to start investing!

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Portfolio Analysis Tools
Now that you know how to find index funds and ETFs for your portfolio, you need a way to check whether or not they meet your asset allocation and diversification guidelines, right?  Fortunately, every major online brokerage house and investing research site has quality portfolio analysis tools.

This will be easier to explain with an example:
In this example, you are a Balanced index investor and you currently own the portfolio listed below.

Your Portfolio:

You’d like to make sure your investments align with your asset allocation and diversification targets.  This is just the click of a button at many of the major online brokerages when you just need a basic portfolio analysis.  For this example, we used Morningstar’s Portfolio X-Ray.    Your portfolio analysis came back with the following results:

Most categories look okay but we have two, US Large Cap Growth and US Mid Cap that could use a little tweaking to more closely match our “Balanced” allocation and diversification targets.  This is a common stumbling block for beginners.  The US Mid Cap is the best example, we seem to have almost exactly the amount we need of Mid Caps because we own $7,423 worth of iShares S&P Mid Cap 400 Index and the target is $7,500, right?

The confusion occurs because beginners sometimes forget the nature of a fund.  Stocks match only one category, so it’s easy to know exactly how a single would impact your mix.  A fund, on the other hand, holds an entire portfolio and even though they may say “Large Cap Value” or “Mid Cap”, there will usually be small percentages of other categories in their portfolio.  In our example, US Mid Cap is obviously a category contained in some of the other funds because the percentage is higher than the target even though our iShares S&P Mid Cap 400 Index appears to be right on the money ($7,423 actual Vs $7,500 target).

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Rebalancing
So what does this mean?  It means we have to rebalance our portfolio to adjust the mix.  In order to do this, you have to look at the funds individually to see where there is portfolio overlap.  There are two culprits in this example.  The Mega Cap 300 Value ETF has 4% of its holdings in Mid Cap and the Vanguard Small-Cap Index Fund has a whopping 35% of its holdings in Mid Cap.  Both of these funds are increasing the overall % in the Mid Cap category.

What’s the fastest way to fix this?  You could rebalance immediately.  By taking a sizeable chunk out of your iShares S&P Mid Cap 400 Index fund and adding about 80% of the dollars back to your iShares S&P 100 Index Large Cap Growth Fund and 20% of the dollars to your Vanguard Small-Cap Index Fund you will get much closer to your targets.  However, this is an expensive way to rebalance because it will require several transactions, there is a better alternative.

A much more cost efficient way to correct your portfolio is to start investing your money in the categories that will correct your mix.  You’re a dollar cost averager, right?  Click here to review why you should be if you’re not, Basic Investing Principle #3, Dollar Cost Averaging.  If you find a couple no-load no-fee Index Funds that invest exclusively in Large Caps and Small Caps, you can invest your money in these two funds until your mix gets closer to the “Balanced” portfolio targets.  Not as fast a fix, but you weren’t that far off to begin with so there’s no reason to eat a bunch of transaction costs when you only need to tweak your portfolio.

Okay, okay, you’re right, that was kind of a magically convenient example of portfolio rebalancing but we’re guessing you’re getting close to the point of information overload.  Read and reread as often as you need to, nothing in this guide is overly complicated but there is a LOT of information.

If you are one of our more technically and analytically minded beginners, this section probably has you itching to learn more about Morningstar.com’s powerful research and analysis tools.  This guide is focused on Index Investing, not on using Morningstar, so we only grazed the surface of what their screening and portfolio analysis tools can do.  If you want to learn more about their site, read our Morningstar.com, the Power of Institutional Investors at your Fingertips guide.

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Track your performance
Can you guess where we’re going to send you?  That’s right, Morningstar.com.  Sick of hearing about them yet?  We love their site, too bad we don’t get a nickel every time we drop their name.  Tracking performance doesn’t even require that you subscribe to their premium services, all the tracking tools you need are available for free.

Remember that we said Index Fund and ETF performance is never “good” or “bad”… well, we want to amend that to say it can be bad if your fund’s returns don’t match the index it is supposedly bound to.  Performance tracking is a simple affair for the index investor, you are only checking in every few months to make sure that each Index Fund and ETF in your portfolio is still closely tracking its Indexes.  If they are lagging, that means they are either carrying too many expenses or are not mirroring their index appropriately when they do their daily rebalances.  When you see a fund lagging an index, check others that track the same one and switch if they have a better expense structure and are more accurately tracking the index.

Why use Morningstar for this?  Because their charts automatically compare each Index Fund and ETF to its respective index.  This saves you a lot of legwork.  You won’t have to spend time figuring out which index to compare to, what the index ticker is, and how to set up the chart, the default chart does all of this for you.  Let’s test this out so you can see for yourself how easy performance tracking really is for an index investor.  Click on this link to open another window to Morningstar.com.  In the top left corner in the box beside the word “Quote” type in VFINX and hit Enter.  The following graph should pop up.

Performance More>>
Growth of $10,000

	Fund		Current Category		Index

Next, click on the “More>>” link in the top left corner of the chart.  The following graph should pop up.

The red line is our fund, the green line is the index, and the orange category line is all the other index funds and ETFs that track the S&P 500.  Since we can’t even see the green line, we know that our fund is tracking its index very accurately.  Since the category line runs below both, we also know that our fund tracks its index much more accurately than other S&P 500 tracking funds.  For a little more detail, we can also review the performance history chart.  It tells us much the same thing, our fund only trailed the S&P 500 by about 0.15%, which is its expense ratio so that makes perfect sense.

You will also want to evaluate your total portfolio’s performance.  This is almost as simple as individual fund tracking but the process can be a little bit more manual.  The easiest method is to keep track of your total portfolio balance at the end of each month and compare your gain or loss to broad indices like the S&P; 500 (largest US companies) and Wilshire 5000 (total US market).  One last note.  Many beginners love to compare their portfolio monthly, weekly, even daily.  We love your enthusiasm, but… Short term comparisons can be very misleading due to volatility, we suggest that you compare over longer periods of time such as in the chart below.  Longer time periods will give you a much clearer picture of your true performance.

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Conclusion:
You did it, that’s everything you need to know to get started!  You’ve learned the benefits and drawbacks of index investing, how to do your own research and select appropriate index funds and ETFs, how to track your performance, and even how to build a perfectly allocated and diversified Index Portfolio.  You have the knowledge of a capable index investor and should beat 80% of professional fund managers and an even higher percentage of individual investors as long as you stick to your strategy, congratulations!

This is our last opportunity to pass on Index Investing advice.  We can’t pass that up can we?  Yes, you will beat 80% of professional investors.  Yes, you will beat beginners that choose to start with more complex strategies such as Value Investing or Growth Investing.  However, don’t expect your portfolio to always go up and always beat every broad index all the time.  Sometimes the market will pop when conditions are extremely bullish and this can make it feel like your portfolio is lagging the indexes.  Don’t worry, you will shine during bearish, choppy, and volatile markets, your well planned blend of different assets across many categories maximizes returns while minimizing potential losses so you will ALWAYS win out in the long-term.  Find high quality Index Funds and ETFs, follow the asset allocation and diversification guidelines you just learned, and then BUY AND HOLD.

At this point, many readers agree that they understand how to build an index portfolio but would still like to see real examples of well-balanced Index portfolios comprised of high-quality Index Funds and ETFs.  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 a lot of monthly commentary related to index investing to help you stay in tune with 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.

That’s the end of this guide, ready for more?  Our next section in the Introduction to Investing Strategies Guide is the Complete Guide to Value Investing.  Enjoy!

If you’re not ready to jump into another in-depth strategy guide, skip ahead to our Investing Strategy Reviews. Our reviews will cover the major goals, investment selection methods, strengths, weaknesses, risks, and long-term outlook for 8 of the most popular investing strategies. Very likely, you will be excited about several strategies since great investors have used them to outperform their peers and the market for decades.  That is exactly why we conclude each review with a look at the investor profile best suited to each strategy.  Pay particular attention to this section.  You will not be able to master a strategy if it is at odds with your personality, risk tolerance, or investing goals.