- Investors looking to simplify can get by with a stock index and a diversified bond index.
- Keep an eye on asset allocation, the mix of stocks versus bonds and other savings vehicles, in your portfolio.
- The average index fund charges about half as much as funds that are actively managed.
If you subscribe to Nobel Prize winner Paul Samuelson's philosophy that "investing should be more like watching paint dry or grass grow," then you're likely drawn to indexing. Given the sheer number of index funds, an all-index portfolio is not hard to come by.
"For the vast majority of investors, putting together a simple, straightforward portfolio of index funds will be easy to construct and simple to manage on an ongoing basis," said Dan Egan, director of behavioral finance and investments at robo-advisor firm Betterment.
Not only are well-diversified index funds widely available, they're also inexpensive. According to data from Morningstar, the average index fund charges about half as much as funds that are actively managed. And fees, Morningstar research says, are more predictive of investment performance than picking the right investment.
It doesn't take much to create an all-index portfolio.
"The good news is that if you want diversification, indexing is the way to do it," said Michael Iachini, vice president and head of manager research at Charles Schwab Investment Advisory.
To keep things really simple, Iachini says, many investors can get by with two just index funds: a stock index and a diversified bond index. Those two funds offer investors exposure to all sizes of publicly traded U.S. companies and several types of bonds, such as corporate investment grade, municipal and high-yield. "With two purchases, you are getting over 10,000 securities," Iachini said.
For example, the holds more than 7,800 names and charges just 21 basis points, and the (VTIBX) fund holds 4,400-plus bonds and has an expense ratio of 15 basis points.
And if investors want to diversify beyond what's in the stock and bond funds, there are also funds that invest in real estate investment trusts or commodities that can provide some uncorrelated exposure.
Given how many index funds there are to choose from, investors might find it hard to stick to just two.
"That's the challenge if you want to be an index investor," said certified financial planner Lee McGowan, managing director and partner of Monument Group Wealth Advisors. "Which index do you want to include?"
While robo-advisors and other professionally managed portfolios might have a dozen or more index funds, individual investors don't need that many to achieve real diversification, said Egan of Betterment.
"There are things that we are doing in portfolio management—things like tax-loss harvesting and rebalancing—that require complex monitoring," he said. "Our [model] portfolios have up to 12 funds that need to be monitored on an ongoing basis.
"That's going to be hard for a do-it-yourself investor to do," Egan added.
There might be some incremental benefit to be gained through sophisticated strategies such as tax-loss harvesting and ongoing rebalancing, Egan said, but you would be giving up simplicity by doing that.
What's more, said Egan, by focusing on tax-loss harvesting and rebalancing, you might be taking your eye off the ball.
"You're getting distracted by what's really important, which is diversification and cost," he said.
Indexing takes the pressure off from having to research a manager's track record and investment style. Instead, it forces you to make an even more important investment decision: asset allocation. Asset allocation is the proportion of stocks and bonds in your portfolio.
"It's mostly about getting the asset allocation right," Iachini said. "And then you want to monitor it on an ongoing basis and maybe rebalance once a year or anytime there's a big market move."
According to a widely cited study by Gary Brinson, Randolph Hood and Gilbert Beebower in 1986, asset allocation accounts for 90 percent of an investment's variability. In other words, it counts for more than security selection in determining the way a portfolio moves.
"The asset-allocation decision is the single most important decision you make, because that's where the risk is," said Charles Sizemore, founder of Sizemore Capital Management. "The decision — 'Should I buy one ETF or four?' — that's not very important."
The standard rule of thumb to determine how much you should own in stocks is to take 100 and subtract your age. So a 30-year-old would have a 70 percent allocation to equities, while a 50-year-old would have a portfolio evenly split between stocks and bonds.
Given the longevity trends, many investors may need a higher proportion of equities until later in life if they hope to grow their money and outpace inflation. And the decision should also take into account your risk tolerance — that is, how much volatility you can withstand. The higher your appetite for risk is, the greater your exposure to equities can be, no matter your age. Conversely, if you're a 25-year-old who's easily spooked by market decline, you may want to keep more in bonds than your age would suggest.
Some people refer to an all-index portfolio as a "set it and forget it" portfolio. Not exactly. While you don't need to monitor your portfolio manager to ensure that he or she is not straying from the fund's objective and performing well, you do need to keep tabs on the overall portfolio.
Since asset allocation is such an important aspect of portfolio management, you need to make sure you're keeping it intact.
"You want to be sure you stay in balance so your risk profile stays where you want it," Iachini of Schwab said. "An individual investor can do that by themselves, but it takes work."
Rebalancing is important because it can help to reduce your risk after, for example, a strong period of equity gains. And by adding to asset classes that have recently faltered, you're able to buy more shares at a lower price.
There are several methods to rebalancing. Some investors use a prefer a time-based method. You pick few times a year to rebalance — perhaps quarterly or semi-annually. Others rebalance only when their set allocations deviate by a predetermined percentage from their desired allocation, say, 5 percent or 10 percent. Whichever method you choose, make a commitment to do it.
Index investing can be a simple way to achieve diversification and low costs. But don't assume that you can be entirely hands off. You'll still need to make important asset-allocation decisions and monitor your investment to ensure that the portfolio is still invested the way you want.
— By Ilana Polyak, special to CNBC.com