How to Put Together Your First Index Fund Portfolio
Three funds is all you need.
Once you’ve decided to start investing in index funds, the next step is to figure out how to put together a portfolio.
With more than 5,000 indexes out there (more than there are U.S. stocks!), which ones to choose can be confusing. You should stick to broad market index funds, like total market funds, which cover an entire publicly traded market.
Index funds are passively managed, meaning they only seek to track the performance of an index. Actively managed funds employ professional managers that attempt to beat an underlying index and charge higher fees for the chance to outperform. But these actively managed funds don’t have a great track record of beating the index. Even when they do outperform, it’s short-lived, and the higher fees often cancel out those higher returns.
The average investor that wants to keep things as simple as possible should pick one fund that covers their country’s stock market, one fund that covers the rest of the world, and one fund representing their bond market. But first, a few things to think about.
Mutual Funds v. Exchange-Traded Funds
Some index funds are mutual funds and some are exchange-traded funds (ETFs). What’s the difference? Not a ton — both will likely get you to your goal — but there are some considerations:
Cost: While indexed mutual funds come at very low cost, ETFs are sometimes cheaper.
When They Trade: Mutual funds are priced when the market closes for the day. If you purchase shares of a mutual fund, you get the price at market close. ETFs trade throughout the day, so you get the price they are currently trading at the time you execute a trade.
Portability: ETFs are much easier to transfer across accounts, especially if they are taxable accounts. It doesn’t matter so much in a tax-advantaged account like a 401(k) or an IRA, because as long as the money stays in a tax-advantaged account, you won’t owe taxes when selling funds.
How Much International Do You Need?
This is a big debate in investing communities. Some people like 0%. International stocks actually comprise 40% of global stocks. There’s a big difference between 0% and 40%, so I’ve landed on 25%. It depends on how much you want to concentrate your investments in the U.S. One thing to keep in mind is that U.S. companies are already by nature global companies.
Deciding on Bonds
Bonds help stabilize your portfolio and preserve your wealth. Most people in their 20s and 30s don’t need bonds. So if that describes you, I would not hold bonds yet. I don’t hold any in my portfolio because my time horizon is still decades away. I know that a stock market crash can (and at some point will) wipe out 30% or more of my portfolio. I also know that this is a routine event in the stock market every 10 or so years and that these losses are only temporary. Those who avoid selling during a downturn and continue to invest can recover in due time.
Here are some rules of thumb you can use if you want to add bonds.
Your Age in Bonds
If you’re 20 years old, this means you have 20% of your portfolio in bonds. At 30 you would have 30% in bonds, and so on. Personally, I find this to be too conservative.
120 Minus Your Age in Stocks
You take 120, subtract your age, and you have your stock allocation. So at age 20 you should have 100% of your portfolio in stocks, 80% stocks at age 40, 60% stocks at age 60, and so on. The rest will be bonds.
As you get older and your risk tolerance declines, you’ll want to increase your allocation to bonds. This reduces volatility — or the ups and downs — in your portfolio.
Bonds are most efficiently held in tax-advantaged accounts. So if you have access to those, it’s best to keep them out of taxable accounts.
With that in mind, we can start putting together a portfolio.
Creating a Portfolio With Vanguard Funds
My favorite index funds come from Vanguard. John Bogle, the founder of Vanguard, helped pioneer low-fee index funds in the 1970s. At Vanguard, you can choose between their mutual funds or equivalent ETFs. Vanguard mutual funds typically have a $3,000 minimum investment, but you can get started investing in ETFs at the price of one share. If you’re investing outside Vanguard, you should invest in their ETFs. But they both hold identical investments.
For U.S. investors using mutual funds, start with the Vanguard Total Stock Market Index Fund, known by its ticker symbol VTSAX. It invests in 4,025 stocks, or nearly the entire U.S. market. It has an expense ratio of 0.04%, meaning for every $10,000 you invest, you only pay $4 in fees annually.
Next, choose their international fund, the Vanguard Total International Stock Index Fund (VTIAX). This covers 7,765 stocks across the rest of the world1 with an expense ratio of 0.11%.
Finally, if you want bonds, choose the Vanguard Total Bond Market Index Fund (VBTLX) for your broad-market U.S. bond allocation that invests in more than 10,000 bonds, including treasury and corporate bonds, for an expense ratio of 0.05%.
Vanguard Portfolio w/ Mutual Funds
Vanguard Total Stock Market Index Fund Admiral Shares2 (VTSAX) - 0.04%
Vanguard Total International Stock Index Fund Admiral Shares (VTIAX) - 0.11%
Vanguard Total Bond Market Index Fund Admiral Shares (VBTLX) - 0.05%
Or, invest in their ETFs instead:
Vanguard Portfolio w/ ETFs
Vanguard Total Stock Market ETF (VTI) - 0.03%
Vanguard Total International Stock ETF (VXUS) - 0.08%
Vanguard Total Bond Market ETF (BND) - 0.035%
So, a young, aggressive investor’s portfolio might look like this:
VTSAX/VTI - 75%
VTIAX/VXUS - 25%
While a more conservative investor’s portfolio might look something like this:
VTSAX/VTI - 60%
VTIAX/VXUS - 20%
VBTLX/BND - 20%
If you can understand this simple three-fund portfolio and you have no desire to learn more, you’re on your way to successful long-term investing.
Building a Portfolio With Non-Vanguard Index Funds
Vanguard isn’t the only index fund provider. Fidelity, Charles Schwab, BlackRock and many others also offer them. Let’s apply the index portfolio above to those three.
Fidelity
Fidelity Total Market Index Fund (FSKAX) - 0.015%
Fidelity Total International Index Fund (FTIHX) - 0.06%
Fidelity U.S. Bond Index Fund (FXNAX) - 0.025%
Charles Schwab
Mutual Funds:
Schwab Total Stock Market Index Fund (SWTSX) - 0.03%
Schwab International Index Fund (SWISX) - 0.06%
Schwab U.S. Aggregate Bond Index Fund (SWAGX) - 0.04%
ETFs:
Schwab US Broad Market ETF (SCHB) - 0.03%
Schwab International Equity ETF (SCHF) - 0.06%
Schwab U.S. Aggregate Bond ETF (SCHZ) - 0.04%
BlackRock’s iShares
iShares Core S&P Total U.S. Stock Market ETF (ITOT) - 0.03%
iShares Core MSCI Total International Stock ETF (IXUS) - 0.09%
iShares Core U.S. Aggregate Bond ETF (AGG) - 0.04%
Summing it Up
The best thing you can do to get started is create a portfolio of low-cost index funds appropriate for your age and risk tolerance and stick to it. Attempting to time the market can lead to losses in your portfolio. So will making changes to your portfolio because of market events or news headlines.
Resist the temptation to check your investments every day. Ignore the short-term ups and downs of the market, and when crashes happen, have the conviction to stick with your allocation for the long term and continue investing.
Some people like to split up international developed markets (Europe, Canada, Japan, Australia) and international emerging markets (China, Taiwan, India, Russia, Brazil), but I think it’s better to keep things simple by just holding the one fund.
“Admiral Shares” simply refers to the share class. If you have Vanguard funds in your 401(k), you might see a total stock market fund “Institutional Shares” with an even lower expense ratio.