A low-cost road to long-term investing: Index funds.
I believe that investors are generally better off when they keep things simple. So for that reason alone, I'd go with index funds.
You can make a very nice diversified portfolio for yourself by combining just two funds: a total stock market index fund ( and a )total bond market index fund (. That would give you a portfolio that covers all sectors of the U.S. stock market -- large and small caps, value and growth shares, virtually every industry -- as well as the entire investment-grade taxable bond market, including government and corporate bonds. )
You would do just fine if you stopped there.
But if you want to add some exposure to foreign markets -- which over the long run can reduce the volatility of your portfolio overall -- you could also throw in a total international stock index fund (. For guidance on how to divvy up your holdings between stocks and bonds, you can check out our )Fix Your Mix asset allocation tool.
Simplicity aside, this approach offers another huge benefit: low annual expenses.
By sticking to diversified stock and bond index funds, you'll likely pay yearly fees of less than 0.25% of the amount invested, in some cases less than half that figure. Regular, or actively managed, mutual funds on the other hand, often charge 1% of assets or more. And while there's no guarantee that lower expenses leads to better performance, there's plenty of evidence that's the case, including this 2010 Morningstar study.
Oh, and there's one more reason I prefer index funds: You know exactly what you're getting. As their name implies, index funds track a particular index or stock market benchmark. The fund holds all, or in some cases a representative sample, of the stocks in the index and nothing more (except, perhaps, a smidgen of cash to accommodate redeeming shareholders).
Managers of actively managed funds, by contrast, have lots of wiggle room when it comes to investing.
So even though a fund may purport to specialize in, say, domestic large-cap value stocks, it's not unusual to find a manager making forays into small-caps, growth stocks or even foreign shares in an attempt to juice returns. This sort of "adventurism" makes it harder to use actively managed funds as building blocks for a diversified portfolio in which you're counting on each fund to play a specific role.
But as much as I believe index funds are the better choice, I don't think you'd be jeopardizing your financial future by devoting a portion of your investing stash to actively managed funds. And if that's the way you want to roll, you should have no trouble finding funds run by smart managers with solid long-term records who can do a credible job of investing your money.
In that case, you might employ a version of what's known as a "core and explore" strategy: put most of your money into index funds and then round out your portfolio with some well-chosen actively managed funds.
How much of your dough goes into the core vs. explore is up to you. But to prevent any bad picks from undermining your portfolio's overall performance, I'd recommend keeping the active portion of your holdings pretty small, say, 10% to 15%.
There's one other thing you'll want to be careful about if you decide to take this hybrid approach. Some advisers suggest using index funds in "efficient" markets like those for U.S. and developed country large-cap stocks and recommend actively managed funds for "inefficient" markets like those for small-caps and emerging market stocks. But identifying efficient vs. inefficient markets isn't quite so simple, and finding active managers who consistently outperform is difficult in almost any market.
So I'd recommend that you get exposure to all markets with index funds and then add the actively managed funds you like even if it means you'll have a bit of overlap in some areas.
I also suggest that as much as possible you go with actively managed funds that have reasonable expenses, as that should give those funds a better shot at competitive performance. You can find such funds, as well as all the index funds you'll need, on our MONEY 70 list of recommended funds.
To sum up, I think most investors would be best served if they just stick with a straightforward portfolio of broad index funds.
Human nature being what it is, however, many people will give in to the urge to venture beyond the indexes for the thrill (even if only fleeting) of finding a fund that beats the market. If you're one of those people, fine. Just don't let yielding to that urge undermine your investing results.
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