Low-cost investing can be a great way to diversify and strengthen your portfolio, but it’s wise to understand the basics before you get started.
What Makes a Good Portfolio?
Portfolios will vary greatly from person to person, depending on your financial and investment goals. If your portfolio provides the returns you expect at a level of risk you’re comfortable with, you have a ‘good’ portfolio.
In general, a ‘good’ portfolio has 3 key characteristics:
- It’s diverse. Don’t put all of your eggs in one basket. A diverse portfolio has a variety of asset classes and types.
- It fits your risk tolerance. Your investments shouldn’t keep you up at night because they are too risky. But they also shouldn’t be so conservative that you can’t meet your financial goals.
- It’s cost-efficient. Professional investment management costs money, but it shouldn’t break the bank.
These three characteristics make up index funds, which could make them an excellent addition to your portfolio.
What are Index Funds?
Index funds are investment funds that follow and track a benchmark index like the S&P 500, Dow Jones Industrial Average, or the Nasdaq 100. They are also referred to as mutual funds or exchange-traded funds (ETG).
Index funds are passively managed, which means that the fund manager picks one index to track and then copies its holdings instead of individually choosing each stock or bond the fund will hold. That’s why people may refer to indexing as a “passive” investment strategy.
There are many benefits to index funds:
- Portfolio diversification: Investing in index funds helps diversify your portfolio, minimizing the amount of risk you incur. Each index fund has hundreds or thousands of stocks or bonds, so if one isn’t performing well, there’s a high chance that another is performing above average, this minimizes your potential losses.
- Cost-efficient: Actively managed funds cost more because portfolio managers have to spend a significant amount of time hand-selecting stocks or bonds. Since index funds are passively managed, you don’t have to pay for that extra time.
- Tax-efficient: Index funds offer lower taxes than other investment opportunities. Because index funds are not actively managed, their stock or bond holdings don’t change as often which often results in fewer taxable gains.
Let’s take a look at 3 types of index funds.
#1 Total U.S. Stock Market Funds
A total stock market fund is a mutual or exchange-traded fund that holds every stock in a selected market. These track indexes include all publicly traded US companies and are especially ideal for investors who want broad exposure to the stock market with minimal effort.
Investing in a total stock market fund is a great way for investors to diversify their portfolio in a cost-effective way. Some examples include the Schwab Total Stock Market Index (SWTSX) and the Vanguard Total Stock Market Index Fund (VTSAX).
#2 S&P 500 Index Funds
The Standard & Poor’s (S&P) 500 is a stock index that consists of the 500 largest companies in the US. It’s considered the best indicator of the stock market’s performance and provides a statistical measure of the performance of the US’s 500 largest stocks. Because of that, it’s a common benchmark used to evaluate your portfolio.
The performance of these companies is tracked by market capitalization—which is the total value of a company’s publicly traded outstanding shares. Some of the more popular S&P 500 index funds include iShares Core S&P 500 ETF (IVV), Schwab S&P 500 index fund (SWPPX), and Shelton NASDAQ-100 Index Direct (NASDX).
#3 Index Funds by Market Segment
This type of index fund breaks down exchange-traded funds based on their market segment—large-cap, mid-cap, and small-cap. Investing in index funds based on market segments helps tailor your investment portfolio based on your risk tolerance level.
Let’s break down each market segment:
- Large-cap: A large-cap refers to the stock of any publicly traded company valued at more than $10 billion. Well-known companies like Apple, Microsoft, and Amazon fall into this category. Due to these companies’ successes and competitive strength, large-cap stocks have a more reliable profit stream.
- Mid-cap: Mid-cap stocks have market caps between $2-10 billion and are quickly establishing stability and security. They are a great option for investors who prioritize both growth and profitability in their portfolio.
- Small-cap: Stocks with market caps between $300 million and $2 billion fall into the small-cap category. Small-cap stocks tend to offer higher returns, but since these companies are just in the beginning stages, they have a greater chance of failing.
Investing in a bigger allocation of large-cap stocks will result in a more stable, less risky portfolio. On the other hand, if you have a higher risk tolerance and want to grow your portfolio, consider investing in more small to mid-cap stocks.
Is a Low-Cost Index Fund is Right for Me?
Index funds are a great option for many investors that are looking to further diversify their portfolio in a cost-effective way.
Index funds are broad, so you can gain additional portfolio exposure to certain markets with minimal effort. What’s more, you can easily allocate more money to specific stocks or funds to match your risk tolerance, investment preferences, and investment goals.
Is a low-cost index fund right for you? As with everything in investing, it comes down to your personal goals and risk tolerance levels. A financial advisor can help guide you through the process and recommend investment strategies tailored specifically to you.
If you’d like to learn more about how a personalized investment strategy can help you reach your retirement goals, get in touch with a member of our team.