What are Index Funds and Asset Classes Investing?
Making Sense of Index Funds
Part 4 of Best Investing Method Series
This investing series: Best Investing Method using asset classes is based upon the work of Nobel Prize winner Eugene Fama. If you don’t believe me, when I say this is an important investment approach, believe the new Nobel Prize winner, Fama who tested and popularized investing strategies based upon the efficient market hypothesis.
In Part 1: What is the Best Investing Method?, you learned the important research behind simple investing with a diversified asset classes portfolio.
Part 2: Outlined the 8 Steps to Creating a Diversified Asset Classes Portfolio.
In Part 3: In Diversification Strategy; How to Figure out my Risk Tolerance you determined your risk tolerance and were introduced to several investment portfolios for each risk tolerance profile.
In Part 4; What are Index Funds and Asset Classes Investing? (today), you get a list of sample index funds and tips for asset class investing with index funds.
Coming in Part 5: How to Buy Low and Sell High – Asset Classes Investing.
Index Fund Overload
There are too many index funds available and the choices can be mind boggling. I want to help simplify your investments. You only need a couple of mutual funds in your investment portfolio.
I’m going to help narrow down your investment choices.
What is an index fund anyhow?
An index fund is a replica of a current market index.
Index fund discussions are all over the media. But what exactly does stock market index mean?
The stock market is categorized into a variety of groups, called indexes. These categories are helpful in analyzing market behavior. The most popular index and the one used most often to represent the total stock market is the Standard and Poor’s 500 or S & P 500. This index contains 500 of the most widely held stocks and attempts to represent the total U.S. stock market in proportion to their market capitalization (or number of shares multiplied by share price).
Apart from the S & P 500 the world of indexes and their accompanying mutual funds expand to include sector such as “health care sector,” small capitalization stock, developing world markets, value stock, and many more index funds.
For every popular stock market index there are one or more mutual funds and exchange traded funds (ETFs) designed to mirror the particular indexes holdings’ and returns’.
In the earlier articles of this Best Investing Method Series you learned how difficult it is to beat the returns of the stock market indexes.
That’s great, but how do you know which index fund(s) to choose? There are hundreds of index funds and Exchange Traded Funds (ETFs) in every imaginable format, how does one sort through them all?
Fortunately, it’s quite easy to narrow down the index fund universe.
Of the vast world of index funds, you decide how simple or how complex you want your investment portfolio to be.
One can obtain an adequately diversified portfolio with as few as two or three diversified index funds. In a recent Forbes article, Rick Ferri wrote about Three Simple Index Fund Portfolios.
For those who desire a more exhaustive diversification, a portfolio of eight to ten or more index funds is possible. After a certain point, it’s debatable how much diversification benefit there is to adding more funds.
How diversified do I need to be?
Most researchers agree that twenty to thirty individual stocks, representing a variety of sizes and industries, provide sufficient diversification. Each additional stock beyond that point offers marginal benefit. Now, think about a diversified index mutual fund with hundreds of holdings and you realize you don’t need to own more than a few diversified index funds.
What are the Best Index Funds?
Simple is better.
Almost every large discount brokerage company has a stable of index funds. The brand or company doesn’t make much difference. You can also buy funds from any fund family in your discount investment brokerage account.
Asset Classes and Index Fund Investing
Following are popular asset classes and sample index mutual funds and ETFs for each category. This is not an exhaustive list of all index funds or ETFs, nor is this a recommended list. These funds are examples of the types of index and exchange traded funds to use within your asset classes selections.
U. S. Total Stock Market Index Funds
Schwab Total Stock Market Index Fund (SWTX)
Vanguard Total Stock Market Index Fund (Investor Shares) (VTSMX)
U.S. Large Cap U.S. Stock Market Index Funds
Fidelity Spartan 500 Index Fund (FUSEX)
Vanguard 500 Index (VFINX)
Small Capitalization U.S. Stock Market
iShares Russell 2000 ETF (IWM)
Vanguard Small Cap Index (NAESX)
International Stock Market Index Funds
Vanguard FTSE All-World ex-US Index Inv Fund (VFWIX)
Fidelity Spartan International Index (FSIIX)
Total Bond Market
Vanguard Total Bond Market Index Fund (VBTLX)
iShares Core Total US Bond Market ETF (AGG)
Short term and TIPs Bond Market
Short term Corporate Bond Index ETF (BMO)
Treasury Inflation Protected Securities (TIP)
Tips for Index Investing
Fees matter. The lower the management fee of the index fund, the more your money is working. Expect to pay from a low of 0.05% for a rock bottom fee – index fund to 1.3% or more in an actively managed mutual fund. Paying over 1.0% for a mutual fund fee and that fund must make 1.0% before you see any return on your investment.
In a discount brokerage account, you can buy mutual funds run by other companies.
Index fund ETF’s are similar to index mutual funds in that they replicate market indexes. They differ from mutual funds because they are bought and sold throughout the day on the market exchanges and their prices are influenced by supply and demand. That means that during some periods they may sell at a premium or discount to the value of their underlying securities.
Index funds are priced once at the end of each day.
When buying or selling ETF’s the investor usually pays a commission. So these are not great investments for dollar cost averaging (or investing a set amount every month). Although, some discount brokers are selling certain ETF’s for zero commission.
Use this diversification strategy with asset classes investing in your workplace retirement account.
How to Combine Asset Classes with Index Funds Diversification Strategy
1. Go back to Part 3 and review your risk tolerance.
For example: A moderately conservative investor might choose 60% stock investments and 40% fixed asset classes.
2. Choose your asset allocation between stocks and bonds (or fixed assets)
Decide how simple or complex you want to be
If you opt for a simple conservative portfolio.
Your portfolio might look like this:
Conservative Diversified Index Fund Portfolio- Example
- 45% U.S. Total Return Stock Index Fund- Schwab Total Stock Market Index Fund (SWTSX)
- 15% International (ex-US) Stock Index Fund- Vanguard Total International Stock Index Fund (VGTSX)
- 40% Total Bond Index fund- Vanguard Total Bond Market Index Fund (VBMFX)
3. Check out which funds are available in your workplace retirement account and/or discount brokerage account.
The type of fund is more important than the funds family. Vanguard, Fidelity, Charles Schwab and other fund families all offer similar index mutual funds.
4. Buy or transfer monies in appropriate percentages into the Diversified Index Funds.
If you need help with this step, call a representative at the fund company and/or consult with your human resources officer at work.
Caveat; These articles are for information purposes only and not a recommendation to buy or sell any particular financial assets. Also, be mindful of valuations. (Don’t put all your money in the stock market after a long bull market!)
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