Index Investing For Dummies
When you invest in an index fund, you're investing in the entire index — as opposed to picking and choosing individual stocks. But first, you need to know what to look for in an index, how to choose the best funds, and how to keep your investments in balance.
Index Investing: 5 Ways to Identify a Good Index
An index investment is only as good as an index fund, and an index fund can be only as good as the index behind it. So what's an index? It's a standard measure of the changes in performance within a grouping of stocks; this group serves as a benchmark for the stock market as a whole or for particular parts of the market. You can't invest in an index because it's a mathematical measure.
Examples of indices include the Dow Jones Industrial Average and the S&P 500 in the United States, Japan's Nikkei 225, and the British FTSE 100. (The numbers represent the number of stocks within that particular index.)
Following are five ways to recognize quality in an index:
A good index is transparent. You know exactly how many securities it holds and exactly what kinds of securities those are.
There is minimal turnover. If half the securities in the index need to be replaced every year, the fund manager tracking the index will have to do a lot of buying and selling. That raises your costs and sets you up for a nasty tax bite.
The index is logical. Securities are chosen by some objective measure, not by some kind of popularity contest that resembles a high school yearbook committee's choice of best-looking.
Breadth is best. The index includes enough securities to accurately represent a particular market, and the broader the market, the better. Ten stocks or bonds do not represent a market. An index should represent a good portion of the economy.
The index is relevant to the real world. Is the index tracking something that makes sense in your portfolio? An index that tracks the price of pickled beets or grass seed may be interesting, but do you really want to stake your retirement on it?
5 Tips for Choosing the Best Index Funds
When you're ready to invest in index funds, get ready to do some research. Selecting from roughly 300 index mutual funds and over 700 ETFs (exchange-traded funds) can be daunting. Where do you start?
Start with the type of investment that you need for your portfolio. If you need long-term growth, you want stocks. If you need stability, you want bonds. If you already have a portfolio of one or the other, you should be looking to balance that off. Within these two large categories of stocks and bonds you want diversification. You want both U.S. and foreign stocks, and you want both large-company and small-company stocks.
Decide whether you want an index mutual fund or an exchange-traded fund (ETF). This is a secondary issue but still important. ETFs may have lower operating expenses but cost a few bucks to buy and sell. They are often your best option for long-term, buy-and-hold, no-touch-or-tinker investments, but not your best option for accounts where you are making regular contributions or withdrawals. If you're investing in a taxable account, the ETFs may be slightly more tax efficient.
Always look to the bottom line. If you decide you want, say, an ETF that mirrors the S&P 500, you'll find a good number of possibilities, even though all the funds will be pretty much the same. Immediately rule out all of the load funds, and be sure to compare annual operation expenses.
Examine the index behind the scene. A solid house rests on a solid foundation, and so does a solid index fund. The foundation is the index itself, whether that be the S&P 500 or any number of lesser-known indexes.
What about returns? An index fund will do as well as the index it represents, minus the expenses of the fund. Stocks can be expected to return more than bonds over the long run (with greater volatility.) Small cap stock funds can be expected to perform better over the long run than large cap stock funds (also with greater volatility).
Long run means many years, so don't be overly concerned with what an index fund has returned in the past months or even in the last year or two. Such numbers are largely irrelevant. Most investors jump into hot sectors . . . often as those sectors are just about to cool. Resist the urge to chase high returns.
2 Methods for Rebalancing Your Index Investments
Failing to rebalance your index investment portfolio could mean that you're taking on added risk as your diversification dissolves and you become too heavily weighted in one or several types of investment. Your large cap stocks, for example, may outperform your small cap stocks. Your foreign stocks may do better than your domestic stocks. Or your bonds may rise, and your stocks may fall.
Rebalancing also forces you, despite whatever your emotions are telling you, to sell off the recent overachievers and buy up the underachievers. Over the years, you'll find yourself buying low and selling high. That process of buying low and selling high, sometimes known as the rebalancing bonus, may add as much as a full percentage point to your long-term annual average returns.
There are two ways to rebalance your portfolio. Both methods have their fans, and neither is necessarily better than the other. Each approach is fairly easy to do, especially when your portfolio consists of wisely chosen index funds that represent crisp and clear asset classes:
The calendar method: This more common method is to attack your portfolio allocations according to the calendar. Most financial advisors suggest rebalancing every year or every 18 months, with the latter being fine for most folks. If you're living off your portfolio and need to raise regular cash, you may consider doing it every six months.
The advantage to using the calendar is that it gives you a certain discipline and tends to result in less trading (with fewer trading costs and taxes) than using the as-needed basis. The calendar method also ensures that you don't rebalance too often, which allows you to take advantage of the momentum that sometimes drives investments north over a period of months.
If you use the calendar method, consider buying or selling any piece of your portfolio (such as, for example, a large cap growth index fund) that has shrunk or grown more than 10 percent away from its target position. In other words, if your portfolio plan allocates 20 percent to large cap growth, consider buying or selling should your position be greater than 22 percent or fall short of 18 percent.
But someone with a smaller portfolio, or someone with an ETF rather than a mutual fund portfolio, may want to use 15 percent instead of 10 percent. The smaller your portfolio, the smaller the positions, and the greater your trading costs may be. You don't want to spend $10 to trade $100 worth of a single index ETF.
The as-needed method: Here, you eyeball your portfolio more regularly and rebalance if and when things get out of whack — regardless of whether that's a year from the last time you rebalanced or a week and a half. You do your juggling just as soon as you note a large enough swing to warrant a buy or sell.
This approach allows for a potentially larger rebalancing bonus but risks eating up that bonus with trading costs and added taxation. Plus, you may lose out on the momentum that drives some securities higher than they sometimes should probably go.