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 Vanguard Total World Stock Index holds more than 7,800 names and charges just 21 basis points, and the Vanguard Total International Bond Index (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.