(Money Magazine) -- Question: I want to invest some of my savings in the stock market, so I'm thinking of buying a couple of index funds. But with so many options -- large caps, small caps, emerging markets, etc. -- how do I determine how to allocate my money? -- Jonathan B., Washington, D.C.
Answer: Back in the early 2000s when the number of of index funds and ETFs was starting to soar, I interviewed Jack Bogle, the man who created the first stock index fund at Vanguard in 1976, to get his take on the ballooning number of index choices.
Never one to mince words, Jack informed me bluntly that he thought the huge expansion of indexes stood the principle of indexing on its head. Instead of a convenient and effective way for investors to participate in the long-term gains of the market overall, he felt it was being turned into little more than gambling, a way to bet on specific slices of the market. "It reminds me of that tune 'Look What They've Done to My Song, Ma," he told me. "One line says, 'They've tied it up in a plastic bag and turned it upside down.'"That's how I feel about what's going on with my little invention."
If anything, the roster of index funds, ETFs and other exchange-traded products is even longer and more mind-numbing today. Not only can you splice and dice broad market indexes like the Standard & Poor's 500 into sectors (technology, finance) and subsectors (nanotechnology, community banks), you can leverage your bet with ETFs that will deliver up to three times a sector's gain or loss on a daily basis.
Foreign exposure? No problemo. You can buy indexes of stocks representing entire continents (Europe, Asia, Africa), regions (Latin America, the Persian Gulf) or specific countries (Egypt, Israel, Poland ... Peru, anyone?). There's even an ETN, or exchange traded note, designed to capitalize on global warming. (No, it's ticker symbol isn't GORE.)
All this would be great if investors were able to tell which parts of the market or the world were likely to perform best in the future. But I don't think most investors, even the pros, shine in that department.
Which is why I think you're better off sticking to the original premise of indexing, which is gaining broad diversified exposure to the financial markets.
So the most effective way for you to get some of your savings into stocks is to invest in a total stock market index fund. In one portfolio, you'll get the entire U.S. stock market, large-, mid- and small-caps, value and growth shares, all sectors and industries. What's more, since the indexes that such funds track are weighted by each stock's market capitalization or market value, you'll own each stock and segment of the market in proportion to the percentage of stock market value it represents.
So since large-cap stocks account for roughly 70% of all the money invested in the U.S. stock market, your total stock market fund will have about 70% of its assets in large-company stocks with the rest split between mid-caps (about 20%) and small-caps (approximately 10%). I think it makes sense to go with that blend unless you have strong reasons for wanting to put more (or less) money in certain areas than investors overall have done. In other words, you believe you know something your fellow investors don't.
You can invest in a total stock market portfolio two ways. The first is to buy a total stock market index mutual fund. We have two such funds -- one from Vanguard and one from Schwab -- on our Money 70 list of recommended funds. They follow slightly different indexes (and the Schwab fund's required initial investment and annual expenses are lower). But either one will give you the entire U.S. equity market in one shot for a very reasonable price.
The second way you can get the whole domestic stock market in one investment is to buy a total stock market ETF. Until late last year, going the ETF route had a big drawback -- namely, you would have had to pay a brokerage commission in addition to annual operating expenses to buy (and later sell) the ETF. That made investing small sums in ETFs prohibitively expenses.
Opting for an ETF rather than a fund can have some advantages. The annual fees are generally a bit lower for ETFs than for comparable funds. And you can avoid having to meet a fund's required initial minimum investment. That's not a big deal with Schwab, as the minimum is just $100. But it could be an issue with Vanguard and Fidelity, which require a minimum of $3,000 and $10,000 respectively for their total stock market index funds.
Even though you pay no brokerage commission, you'll still have to open a brokerage account at these firms to buy one of their no-trading-fee ETFs. So if you think you'd prefer an ETF to a fund, make sure you're okay with the requirements for opening a brokerage account. Vanguard, for example, charges a $20 annual fee for brokerage accounts that have less than $50,000 worth of Vanguard mutual funds or ETFs. That's hardly a bank breaker, but for small balances it could wipe out much, if not all, of the ETF's expense advantage versus a comparable fund.
The point of all this, though, is that through either index funds or ETFs it's pretty darn easy to get a fully diversified portfolio of U.S. stocks at a low cost, and certainly much, much less than you would pay for most actively managed mutual funds.
I've limited the scope here to U.S. stocks. But you can also get broad exposure to foreign markets without too much trouble through a total international stock market index fund or ETF. The same goes for bonds.
Bottom line: you can pretty much build a fully diversified portfolio of domestic stocks, foreign shares and bonds using as few as three broad index funds or ETFs -- total U.S. stock market, total international stock index and total U.S. bond market.
Of course, you can make the mix more complex, if you want. You can overweight mid or small caps, or do the opposite. You can emphasize growth shares, or stress value stocks. You can throw some money into sectors you think will outperform in the future, say, energy or tech -- or, then again, should it be health care and financials?
Just remember that the more complicated you make your portfolio, the harder it will be to manage, the more it will probably cost you and the greater your chances of underperforming the market overall. In short, far from improving your portfolio, all your extra effort may amount to the equivalent of tying it up a plastic bag and turning it upside down.
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