I’m a confirmed indexer.
It’s a boring way to invest, but it helps me sleep at night while still building wealth for the future.
For many beginner investors, indexing can be a good way to get started. It’s easy to understand the process, you don’t need a lot of money, and the results offer a pretty good bang for your buck.
What is indexing?
Index investing is a strategy that revolves around using index funds. Rather than choosing individual assets, you invest in index funds and ETFs that follow the performance of specific groups of assets.
The idea is to take advantage of the performance of a substantial part of the market, rather than trying to find a few “winning” stocks. You get instant diversity and your overall returns are based on what happens with a group of assets collectively.
Indexing doesn’t just have to be about stocks, even though many of us think of index funds primarily as stock funds. There are bond index funds, and you can invest in ETFs that follow currencies and commodities.
For the most part, though, a traditional long-term indexing strategy focuses on helping you create an asset allocation using stock and bond funds.
Indexing and asset allocation
Asset allocation — the way you divide your portfolio among asset classes — is the cornerstone of index investing. Instead of focusing on individual stocks, bonds, commodities, or other items, you look at the percentage of your portfolio in different asset classes.
Rather than trying to pick ten good stocks and a few good bonds to invest in, you create a portfolio using index funds that follow scores of stocks and bonds. That way, if something does drop, the other items in the fund make up for it so your overall performance is more likely to be positive.
When investing in index funds, the focus is on the types of assets you have in your portfolio, not the individual investments. If you want to add a little diversity, you choose an index fund or ETF from a different asset class.
It’s possible to spread your index funds across sectors, geography, and asset classes in a way that gives you reasonable exposure to different market segments.
A “traditional” asset allocation for a long-term retirement portfolio is to subtract your age from 100 or 120 (depending on your risk tolerance) and invest that percentage in stock funds. The remaining amount is invested in bond funds.
For example, if you’re 25 and you use 120 as your number, your portfolio would be made up of 95 percent stock funds and 5 percent bond funds.
Rebalancing your portfolio
Every so often, it makes sense to change things up in your portfolio. This is known as rebalancing.
As your portfolio grows, you’ll find that some index funds and ETFs do better than others. When that happens, your asset allocation might get out of whack.
Say you want to maintain an 80/20 stock/bond split. However, stocks have been doing well, so the value of the stock index funds in your portfolio have grown. Now, your portfolio looks more like a 90/10 split.
In order to bring your portfolio’s asset allocation back into balance, you sell some of your stock index fund shares and use the proceeds to buy more bond funds.
This strategy works well because you are selling high and (presumably) buying low. This is why many investors and advisors like a stock/bond split.
It’s often said that stocks and bonds move opposite to each other. If stocks are high and you sell some shares, there’s a good chance bonds will be low, so you can use your profits to get a good deal.
Some robo-advisors like Betterment actually rebalance your portfolio automatically when your asset allocation strays too far from your goal. If you rebalance on your own, it makes sense to do so no more than once a year while you’re younger, and then no more than once or twice a year as you get closer to retirement.
Rebalancing too often can mean more fees and reduced efficiency in your portfolio. Indexing is meant largely to be a mostly passive strategy for managing your long-term investments.
It’s actually pretty easy to start investing — and this includes indexing.
Many online brokers allow you to buy fractional shares if you set up an automatic plan. This means that you can buy half a share or even a quarter share, if that’s what you have money for.
In order to start, you just need to open an account with one of the many brokers that allow you to start an account with a small amount of money.
You’ll need identifying information (such as your Social Security number, name, address, and birthdate) and bank account information to set up automatic transfers. Once you have your account set up, decide how much money you want to invest each month and figure out which index fund to start with.
If you have an employer that offers a retirement plan, this is a great chance for you to use a tax-advantaged retirement account to your benefit.
Look over the options and see if you can find a fund that follows a major stock index and get started with that. If your employer matches contributions, invest as much as you can to get the maximum match. That’s free money to grow your portfolio.
Only you know the best way for you to start investing, and you should carefully consider your options and consult with a knowledgeable investment professional before starting.
Indexing has been a good way for me to invest, and it might work for you, too. Don’t expect life-changing returns on your investment — instead, be prepared for solid, reasonable gains meant to help you reach your goals over time.
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