How to Build an Index Fund and ETF Portfolio

In the last lesson you chose a risk profile and learned why diversification and low costs matter. Now you'll turn that into a real portfolio. The strategy you'll learn, index investing, is the approach many of the most respected investors and academics suggest for ordinary savers, because it's simple, cheap and hard to mess up. Warren Buffett has famously said a low-cost S&P 500 index fund makes sense for most investors, and the late Vanguard founder John Bogle built an entire movement around it.

What an index is

An index is a list of stocks (or bonds) that represents a market, built with public rules about what's included and how much each one weighs. Some well-known examples:

• S&P 500: about 500 large U.S. companies, roughly 80% of the U.S. stock market's value.
• Total U.S. stock market indexes (such as the CRSP US Total Market or the Dow Jones U.S. Total Stock Market): large, mid-size and small U.S. companies, thousands of them.
• International indexes (such as the FTSE Global All Cap ex US or MSCI ACWI ex USA): developed and emerging markets outside the U.S.
• Bond indexes (such as the Bloomberg U.S. Aggregate): investment-grade U.S. government, mortgage and corporate bonds.

An index fund doesn't try to guess which companies will do best. It buys everything in the index, in proportion. That's why its costs are so low.

Why it works

1. Maximum diversification: a total-market fund holds thousands of companies; add an international fund and you own most of the world's public companies.
2. Low costs: as you saw in lesson 9, a 1-point difference in fees can cost tens of thousands of dollars over a career.
3. The evidence: S&P's SPIVA reports have shown year after year that most actively managed funds trail their index over long periods, after fees.
4. Fewer decisions: fewer chances to make the behavioral mistakes from lesson 9.

The building blocks of an index portfolio

The classic three-fund portfolio, popularized by the Bogleheads community, is exactly that: a total U.S. stock fund, a total international stock fund and a total U.S. bond fund. Here's a moderate version:

Three sample portfolios

Even a two-fund portfolio (one global stock fund and one bond fund) is better diversified than what many individual investors own.

The one-fund option: target-date funds

If you'd rather not manage anything, a target-date fund holds a ready-made mix of stock and bond index funds that gets more conservative as its target year approaches. Pick the year closest to your retirement (say, 2060) and it rebalances for you. It's often the default in 401(k) plans. Just compare expense ratios, and don't combine it with lots of other funds, or you'll undo its built-in mix.

Practical decisions

ETF or index mutual fund?

Inside a 401(k), you'll usually choose from the plan's menu of mutual funds; look for the lowest-cost index options or a target-date fund. In an IRA or brokerage account, either works.

Dividends: reinvest them

U.S. funds pay out dividends (and bond funds pay interest) rather than accumulating them inside the fund. Turn on automatic dividend reinvestment so that money buys more shares and keeps compounding. In a taxable account, dividends are taxed in the year you receive them even if you reinvest them; in a 401(k), IRA or HSA, they aren't.

Currency and location

International stock funds give you exposure to other currencies, which adds diversification for a U.S. investor. For bonds, whose job is stability, most U.S. investors stick to U.S. dollar bonds, or international bond funds hedged back to dollars. If you have both taxable and retirement accounts, a common tax-saving habit ("asset location") is to hold bonds, whose interest is taxed as ordinary income, in tax-advantaged accounts first.

Rebalancing with real numbers

Say you have a moderate portfolio of $25,000: $15,000 in stocks (60%) and $10,000 in bonds (40%). Over a year, stocks rise 18% and bonds 4%:

To get back to 60/40, stocks should be 60% of $28,100 = $16,860, so you'd move $17,700 − $16,860 = $840 from stocks to bonds. Inside a 401(k) or IRA that's tax-free. In a taxable account, an alternative that avoids selling (and capital gains taxes) is to send new contributions to bonds: here, about $1,400 of new money into bonds would restore 60/40.

Rebalancing forces you to sell a bit of what rose and buy what lagged: the opposite of what your emotions want. Do it once a year, or whenever a weight drifts more than 5 percentage points from its target.

Your investment plan in one paragraph

Write it down and reread it the next time the market drops:

"I invest $____ every month, on day ____, in a portfolio of ___% U.S. stocks /
___% international stocks / ___% bonds, through ____ (account and brokerage).
I reinvest dividends and rebalance every ____. I don't sell because the market
fell; I only change the plan if my goals or my situation change."

Summary

• An index fund tracks a whole market at very low cost.
• A two- or three-fund portfolio (U.S. stocks, international stocks, bonds) is enough for most people; a target-date fund does it in one.
• ETFs and index mutual funds both work; compare expense ratios and turn on dividend reinvestment.
• Hold bonds in tax-advantaged accounts when you can, and keep bond money in dollars.
• Rebalance once a year or with new contributions; write your plan down for the next downturn.

Next lesson: How to Analyze a Mutual Fund or ETF Before You Invest. You'll learn what to check in a fact sheet and prospectus, and which red flags should make you look elsewhere.