Too many investors obsess over beating the annual return of major market indexes such as the S&P 500. If matching the performance of indexes is sufficient to meet your retirement needs, here’s how to create a portfolio using index funds – funds that simply track a particular index and make no attempt to beat it.
Step 1: Determine your ideal asset allocation. That boils down to finding your comfort zone between stocks, bonds, and cash. Visit the site of the Mutual Fund Education Alliance (www.mfea.com) for sample asset allocations and links.
Step 2: On the stock side, you’ll want a stable and diversified group of the largest U.S. corporations across the full swath of industries. You can do that by investing in one broad market index fund that covers large-, mid- and small-cap stocks.
Step 3: If you prefer to build the stock portion of your portfolio with multiple index funds, consider investing up to two-thirds of your stock allocation in an S&P 500 fund (large-cap) and up to 20% in an “extended-market fund,” which invests in small- and mid-cap stocks.
Step 4: To further diversify, consider investing 10 percent or more of your stock allocation in a foreign large-cap blend fund, which will give you broad international exposure.
Step 5: Round out your portfolio by investing your bond allocation in an intermediate-term bond fund.
How to beat major market indexes
Investors who want their portfolio to outperform market indexes usually choose actively managed funds. But many of these funds charge steep management fees, generate higher taxes (when they’re held in taxable accounts) and still fail to beat major indexes, such as the S&P 500 over time. How to improve your odds of finding an actively managed fund that will outperform market indexes:
Step 1: Look first only at no-load funds. Funds without sales charges generally produce higher returns than load funds.
Step 2: Identify no-load funds with the lowest expense ratios. While no-loads generally are less expensive to own, some have higher management fees that eat deeper into returns.
Step 3: Now look at those no-load, low-fee funds. Check off the ones with the most assets under management. These tend to remain active longer over time, and their fund companies are more likely to devote more resources to them.
Step 4: Finally, choose the no-load, low-fee, high-asset funds whose managers have been in place for at least two years,
All of this information can be researched through your broker or at www.morningstar.com.