How to build a diversified portfolio by investing in Index Funds

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Index funds have outperformed all but a few of the actively managed mutual funds. So for people who do not have time to research and find stocks or mutual funds which beat the market, it is best to stay with the market. The market in the long run historically has returned about 8%.

What are Index funds? Index funds consist of stocks in the same proportion as a market index like S&P 500 which tracks US domestic stocks or MSCI EAFE which tracks international stocks

Advantages of index funds - Index funds have low fees, are tax efficient because of low turnover and are automatically diversified Disadvantages of index funds - They are boring and you can never beat the market

Modern portfolio theory (MPT) by Harry Markowitz shows us how to maximize returns while minimizing risk. His observation was that different types of stocks and bonds respond differently to the same market conditions. So you have to build a portfolio of asset classes which behave differently to market conditions and come up with percentages for each asset class.

So to build a portfolio which maximizes returns and minimizes risks, you have to hold a variety of asset classes in your portfolio. And the best way to hold a variety of asset classes is through index funds.

  • Determine your long term (like retirement) and short term (like kid's college) goals. - Based on each goal come up with an investment plan. Many mutual fund websites help you plan for the above two. I have included links to Fidelity and Vanguard websites below.

Now to build your portfolio there are 4 major asset classes you need to consider - US Stocks, International Stocks, Bonds and short term funds. The one mutual fund company I know of which offers index funds in all four asset classes in Vanguard.

US Stocks To achieve the MPT diversification when investing in US stocks do not limit yourself to large blue-chip companies. Consider the smaller and growing companies in niche markets as well. Also consider other areas like REIT. To find index funds you can do a search with your brokerage firm for index funds which track these.

Some examples are Large Cap
- Fidelity Spartan U.S. Equity Index Fund (FUSEX) (S&P 500) - Fidelity Spartan Total Market Index Fund (FSTMX) - Vanguard 500 Index fund (S&P 500) - T Rowe Price Equity Index Fund (S&P 500) Mid Cap - Fidelity Spartan Extended Market Index Fund (FSEMX) - Vanguard Extended Market Index Small Cap - Charles Schwab Small Cap Index Fund - Vanguard Small Cap Index Fund US REIT - Vanguard REIT Index Fund - Wells DJ REIT Index Fund

International Stocks Just like the diversification of US stocks, you need to include not only developed countries stock but also emerging market stock. You can also seek region wise diversification like Europe and Asia. Here are some examples - Vanguard Developed market index - Vanguard European Stock Index - Vanguard Pacific Stock Index - Vanguard Emerging Market Index

Short and Long Term Bonds Here are some examples of Bond Index Funds - Vanguard Total Bond Index - Vanguard Long Term Index - Vanguard Short Term Index - Fidelity US Bond Index

Now you know the different types of asset classes and the different index funds available, the last thing to be done is assign weightages or percentages to the different asset classes to build your portfolio If you are a young person then you can afford to take more risk since you have longer time to recover any downs in the market. So here are some suggestions For a young person - 50% US Stock out of which 20% large Cap, 10% Small and 10% REIT - 30% International of which 20% Developed and 10% Emerging Market - 20% Bonds with 15% Total Bond and 5% Short Term For a Middle Aged person - 45% US Stock out of which 20% large Cap, 7% Small and 8% REIT - 25% International of which 20% Developed and 5% Emerging Market - 30% Bonds with 25% Total Bond and 5% Short Term For a recently retired person - 45% US Stock out of which 25% large Cap, 10% Small and 10% REIT - 15% International of which 10% Developed and 5% Emerging Market - 40% Bonds with 30% Long Term and 10% Short Term

Tips & Warnings

  • Whenever any asset class deviates from plan by more than 5% either way try to re-balance to bring it back to plan
  • Instead of rebalancing, you can redirect new investment dollars to other asset classes which are lower than plan
  • Remember when you do your asset allocation you have to combine all your accounts like IRA, 401Ks, Taxable accounts, etc.
  • Do not let emotions drive your investments. Always try to stick to your plan whatever happens in the market
  • Don't try to time the market. Always invest a fixed amount periodically

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