So, what exactly is index investing? What makes it better than other strategies for building a portfolio? And how exactly do you go about building a portfolio based on index funds? We are going to cover all of these questions—and more—over the scope of this guide, but it’s important to first have a good understanding of what index investing is (and what differentiates it from other strategies). Over the next couple of parts in the guide, we are going to focus on building a foundation of knowledge regarding the strategy.
To start, let’s get into the two basic components we’ll be using for portfolio composition: stocks and bonds. There are, of course, more instruments out there aside from these two, but these are the ones you will hear about most often, and for good reason: they are two of the best core components you can choose for a portfolio. So, what are they?
A stock is a type of investment that represents a small piece of ownership in a specific company. These pieces of ownership are sold in units called shares. A company typically decides to “go public” (start selling shares) in order to raise capital, and the owners agree to give up a certain amount of ownership to shareholders in exchange for the capital they raise. When you purchase a share of stock in a specific company, you actually own a small sliver of that company! In fact, if you were to own a very large number of shares in that company, you could actually reach a point where you begin to exert a certain amount of influence over that company. Shares of stock are sold on exchanges, which connect buyers and sellers; you’ve likely heard of some of these (such as the New York Stock Exchange, or NYSE, and the NASDAQ).
A stock is a type of investment that represents a small piece of ownership in a specific company. When you purchase a share of stock in a specific company, you actually own a small sliver of that company!
Whether a company’s stock is actually valuable or not largely depends on how the company performs; if it does well, the value of its shares will go up (and be in higher demand), and if it does poorly, the opposite occurs. This is actually a bit simplified, because most of the time, the share price of a given stock is based on the anticipated value of the share, and this is itself the aggregate of many factors: company reputation, market trends, retail sales, monetary policy, product or service offerings, interest rates, and so on.
As you might imagine, a lot of work, time and expense is put in by investors who attempt to predict and make a profit from the movement of individual stocks. However, stock-picking, as we’ll see a bit later on, is not a workable, sustainable strategy. Research shows that even “professional” stock-pickers (active fund managers) have an extremely hard time consistently beating the market; in fact, only 10-15% of them succeed over longer windows of time (20 years+). And, again, these are professionals—the odds for individual investors are undoubtedly much worse. So what is the alternative? Read on.
A bond is simply a financial instrument that represents a loan made by an investor (such as you) to a borrower (usually a corporation or government body). These institutions issue bonds as a way of raising capital. When you buy a bond, you essentially own an IOU from this corporation or government body. You are agreeing to loan the institution money for a specified period of time, during which the borrower agrees to pay you interest (usually in fixed installments). The interest rate for bonds is called the coupon rate. When the period of time is up (called a bond’s maturity date), the borrower agrees to pay you back the face value of the bond.
An example will demonstrate how this works. Let’s say you purchase a $2,000 bond with a 10-year term from Microsoft, and this bond has a coupon rate of 10%. What this means is that Microsoft will pay you $200 per year in interest (10% of $2,000); this is paid to you every year until the bond’s maturity date. When the bond matures (10 years later), Microsoft will pay you back the face value ($2,000) of the bond.
As you might imagine, there are many, many different kinds of bonds available on the bond market. Bonds can be categorized by type (such as bonds issued by the U.S. Treasury Department, bonds issued by municipalities, and bonds issued by corporations), their term (short-, medium-, or long-term), the creditworthiness of the issuer (there are several ratings systems in place that rate bonds by risk level), and so on. We are not going to spend much time breaking down the differences here, as we will spend more time on it in Part 7. Here’s the short version: we will be investing in bonds in the form of broad-market bond funds, which offer exposure to investment-grade (think quality) bonds of all different maturities (short-, medium-, and long-term). These types of funds offer diversification within the bond market, and are frankly, a much simpler way to own bonds.
Risk and Return
We are going to spend some time here on a key point: stocks and bonds have very different risk and return profiles. Stocks are typically much more volatile (meaning that their value can change rapidly and unpredictably—sometimes drastically) and thereby riskier for investors. Bonds, on the other hand, are relatively stable (their value does not fluctuate nearly as wildly as stocks). However, with greater risk comes the potential for greater reward: in exchange for the higher risk that investors take on with stocks, they have the potential for far greater returns than bonds.
An example will help. This chart shows the performance of two portfolios over a span of 34 years (1987-2021): Portfolio 1 (the blue line) is invested fully in the U.S. stock market, and Portfolio 2 (the red line) fully in the U.S. bond market. Both portfolios started out with a balance of $10,000, and added nothing more. Let’s look at how they perform.
The first thing that quickly becomes apparent: our portfolio of stocks rises and dips a lot, whereas our portfolio of bonds rises steadily without much movement; this is volatility in a nutshell. Breaking down the actual numbers, the stocks portfolio had a best year (1995) with a +35.79% gain, and a worst year (2008) with a -37.04% loss; the bonds portfolio had a best year (1995) with a +18.18% gain and a worst year (2021, to date) with a loss of -2.72%. The second thing that you will probably notice, however, is that our stocks portfolio performed much better than our bonds portfolio. Our stocks portfolio had an average annual return of 10.89%, and had an ending balance of $347,972, whereas our bonds portfolio brought in an average return of 5.77% and had an ending balance of $68,560.
The differences between stocks and bonds—both in terms of return potential and risk—is critical to understand, and will play a large part in your portfolio construction. Here’s the important part for our purposes: by adjusting the mix of stocks and bonds in your portfolio, you adjust both the potential for return as well as the risk profile of your portfolio. We will get into this more in depth later, when we discuss your asset allocation in Part 9, but it’s good to touch on here as well.
…by adjusting the mix of stocks and bonds in your portfolio, you adjust both the potential for return as well as the risk profile of your portfolio.
Okay, so with literally tens of thousands of options out there for individual stocks and bonds, how does anyone know which ones to pick for their portfolio? And doesn’t building a well-diversified portfolio of both stocks and bonds get very complicated, very fast? Luckily, no. There is a much better option for simplification and diversification: funds. These take two main forms—mutual funds, and exchange-traded funds (ETFs)—and these are the vehicles we will be using to build your portfolio. In Part 5, we are going to look at what they are, as well as the two dominant philosophies that guide how they are run.
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