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How to build a low-cost portfolio with index funds

If you are looking for a simple and effective way to invest your money for the long term, index funds might be the answer. Index funds are mutual funds or exchange-traded funds (ETFs) that track the performance of a specific market index, such as the S&P 500, the Nasdaq Composite, or the MSCI EAFE. By investing in index funds, you can enjoy several benefits, such as:

– Low fees: Index funds have lower operating expenses and management fees than actively managed funds, because they do not require a lot of research or trading by fund managers. According to Investopedia, the average expense ratio for index funds was 0.09% in 2020, compared to 0.66% for actively managed funds.

– Broad diversification: Index funds provide exposure to a large number of securities in a single fund, which reduces your overall risk and volatility. For example, an index fund that tracks the S&P 500 will hold shares of 500 large U.S. companies across various sectors and industries.

– Market-matching returns: Index funds aim to match the risk and return of the market they track, based on the theory that in the long term, the market will outperform any single investment or fund manager. According to Morningstar, only 24% of actively managed U.S. stock funds beat their index counterparts over the 10-year period ending June 30, 2020.

So how can you build a low-cost portfolio with index funds? Here are some steps to follow:

1. Decide on your asset allocation: Asset allocation is how you divide your money among different types of investments, such as stocks, bonds, and cash. Your asset allocation should reflect your risk tolerance, time horizon, and financial goals. A common rule of thumb is to subtract your age from 100 and invest that percentage in stocks, and the rest in bonds. For example, if you are 40 years old, you could invest 60% in stocks and 40% in bonds.

2. Choose your index funds: Once you have decided on your asset allocation, you need to select the index funds that will make up your portfolio. You can choose from a variety of index funds that track different markets and segments, such as U.S. stocks, international stocks, U.S. bonds, corporate bonds, etc. You can also opt for target-date funds or asset allocation funds that automatically adjust your asset mix based on your age or risk profile.

3. Open an account and start investing: You can buy index funds through your brokerage account or directly from an index-fund provider, such as Fidelity or Vanguard. You will need to pay attention to the minimum investment requirements, commission fees, and expense ratios of each fund. You can also set up automatic contributions to your account to make investing easier and more consistent.

4. Rebalance your portfolio periodically: Over time, your portfolio may drift away from your desired asset allocation due to market fluctuations or changes in your circumstances. You should review your portfolio at least once a year and rebalance it if necessary by selling some of your overperforming funds and buying more of your underperforming ones. This will help you maintain your risk level and avoid emotional investing.

By following these steps, you can build a low-cost portfolio with index funds that will help you achieve your long-term financial goals.