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As miserably as Standard and Poor's 500-stock index has performed recently, it still has beaten two-thirds of big-company U.S.-stock funds over the past five years. And that, in a nutshell, is why simple portfolios of index mutual funds still make sound financial sense for many investors: They're a dependable way to get better-than-average returns.
Index funds seek to mirror a variety of barometers of the stock and bond markets. Rather than attempt to outpace the markets, these funds aim to match the performance of their indexes -- saving you the time and effort of trying to pick actively managed funds that you hope can consistently outperform the markets. Funds that are actively managed often beat their benchmarks over short periods of time, but few of them outperform over the long haul.
Why do index funds do so well? Mainly, it's because of their low costs. Index funds don't require highly paid managers and analysts to research companies, so they're generally cheap to operate. Vanguard 500 Index (symbol VFINX) carries an annual expense ratio of 0.15%, meaning that for every $1,000 you have in the fund, Vanguard will extract just $1.50 per year for operating costs. That compares with an average expense ratio of 1.4% for all diversified U.S.-stock funds.
Consider the impact of this on a $100,000 portfolio that earns 10% per year before fees. Compared with someone who owns a fund that charges the average expense ratio, an investor in Vanguard 500 Index would earn an additional $28,000 over ten years (not including the impact of taxes).
Because different parts of the stock market often move independently of each other, you can build a portfolio with steadier results by holding funds that focus on different areas. For example, in 2001 the S&P 500 lost 12%. But the Russell 2000, which tracks 2000 small U.S. companies, rose 2.5%.
In reviewing the portfolios of index funds Kiplinger's has recommended over the past ten years, we didn't find any that disappointed. So based on our tried-and-true methodology, we offer three portfolios for different goals:
Long term: 10-plus years away
Here's an all-stock portfolio that covers not just big and small U.S. companies, but foreign stocks and real estate as well. We've chosen Vanguard index funds, but you can just as easily use other low-cost index funds and exchange-traded funds that cover the same territory. The iShares brand of ETFs (iShares S&P 500 for big-company stocks and iShares Russell 2000 for small-company stocks, for example) would work just as well.
This portfolio returned an annualized 6.4% for the past three years through July 31 and 12.4% for the past five. Compare that with 2.9% and 7% for the S&P 500.
35% Vanguard 500 Index (VFINX) -- Large-company U.S. stocks
25% Vanguard Small-Cap (NAESX) -- Small-company U.S. stocks
25% Vanguard Total International Stock (VGTSX) -- Big-company overseas stocks
10% Vanguard REIT (VGSIX) -- Real Estate Investment Trust
5% Vanguard Emerging Markets Stock (VEIEX) -- Emerging-country stocks
Medium term: 5 to 10 years away
You're getting closer to your goal-be it funding retirement, paying for college or fulfilling some other large call on cash-so we've reduced the risk of this portfolio by allocating 30% to a bond fund, which should help your portfolio achieve smoother performance. Less volatile than the long-term portfolio, this collection returned 4.9% and 9.2% annualized over the past three and five years, respectively.
30% Vanguard 500 Index (VFINX) -- Large-company U.S. stocks
30% Vanguard Total Bond Market (VBMFX) -- Broad bond index
15% Vanguard Small-Cap (NAESX) -- Small-company U.S. stocks
15% Vanguard Total International Stock (VGTSX) -- Big-company overseas stocks
10% Vanguard REIT VGSIX) -- Real Estate Investment Trust
Short term: Fewer than 5 years away
You need to think more in terms of preservation of capital and current income, so we've bumped up the weighting in bond funds to 40%. The least volatile of the three portfolios, it returned an annualized 5% and 8.7%, respectively, over the past three and five years.
30% Vanguard Total Bond Market (VBMFX) -- Broad bond index
25% Vanguard 500 Index (VFINX) -- Large-company U.S. stocks
10% Vanguard Short-Term Bond (VBISX) -- Mainly U.S. Treasuries
10% Vanguard Small-Cap (NAESX) -- Small-company U.S. stocks
15%Vanguard Total International Stock (VGTSX) -- Big-company overseas stocks
10% Vanguard REIT (VGSIX) -- Real Estate Investment Trust
POSTED BY: Rimaye (May 17, 2009 01:23 AM)
If "preservation of capital" is important in the short term, why is over 50% of the portfolio allocated to stocks? The events of the past year should have convinced everyone that holding a large portion of one's portfolio in stocks is a risky strategy if your horizon is short.
POSTED BY: Josh (May 20, 2009 04:04 PM)
Bob, thanks for the article. I'm 25 and have a Roth IRA with Vanguard. Since the minimum investments for Vanguard funds are $3,000, it is not possible for me to have smaller percentage allocations yet. What advice do you have? Also, is Vanguard Total Stock Market Index an acceptable substitute for the two US stock funds?
POSTED BY: Bob Frick (May 21, 2009 09:02 AM)
Hey Josh, Bob Frick here. Good question. There is no substitute for diversification, so we recommend people buy ETFs instead of index funds if they haven't yet accumulated enough money to diversify with index funds. You can buy ETFs for a fraction of what you pay for funds because they trade like stocks. Vanguard, for example, has enough ETFs (39 at last count) that you can build a diversified portfolio with them alone. While the Vanguard extended market index fund has a minimum in the thousands, you can buy a single share of the extended market ETF for $33. You have to be careful about fees, though. Since ETFs trade like stocks, you'll be paying a commission everytime you buy and sell. So once you've settled on a portfolio, don't do a lot of trading -- buy and hold is the ticket. I hope this helps. If you have any more questions, feel free to email me at rfrick@kiplinger.com.
POSTED BY: Carroll (June 23, 2009 02:03 PM)
Bob, In the June 2009 issue of Kiplinger's, "An Investor's Manifesto" by Knight Kiplinger (p. 17) reads "My share of bonds equals my age." Suze Orman also recommends a percentage of bonds equal to age. However, in the article posted here and others in the magazine, it is regularly recommended to have most of my holdings in stocks if I have more than 15 years before retirement. I'm 40 and don't plan to retire until 65 - so which is it...40% in bonds (equals my age) or 0-10% in bonds because I have 25 years until retirement? Thanks.
POSTED BY: Bob Frick (June 23, 2009 04:25 PM)
Carroll, Bob Frick here, author of this article. You've asked a great question, and one that unfortunately does not have one great answer, though the bond percentage=age rule-of-thumb certainly comes closest. It may be too conservative for someone in your situation, some might argue, because given in the 25 years you have until retirement, stocks will almost certainly outperform bonds. This is why our favorite target date funds (whole portfolios in a single fund) would be 90% stocks for someone in your position. The historical outperformance of stocks over bonds, over long periods, is also why our advice is often along the same lines. But many people's risk tolerance is such that they need more bonds in their portfolios for stability -- if their portfolios are too volatile, they'll often make bad investment decisions based on fear. A portfolio that you're comfortable with cannot be underestimated. There are other factors as well, which I'd be happy to discuss with you. Feel free to email me at rfrick@kiplinger.com.
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