The Best Types of Index Funds for Diversifying Your Portfolio
The vast majority of people who have even considered investing some of their money understand that diversification is important. It allows you to limit your financial risk by ensuring that all of your cash isn’t sitting in a single stock or another investment vehicle. That way, should a negative event harm one investment’s value, all of your money isn’t lost.
However, there is also a pervasive misconception about investing. Many believe that you need a specialized skill set to diversify a portfolio. In reality, there are options that handle the diversification part of investing for you.
Index funds don’t represent a single stock, bond, or other form of investment. Instead, they attach to larger markets, reflecting a number of investments in a specific category. By choosing index funds, you automatically have a level of diversification. Plus, you may even see higher gains that you would with individual stocks and bonds.
If you want to diversify your investments, here are some funds worth exploring.
Standard & Poor’s 500 (S&P 500)
The S&P 500 index tracks the market capitalization of the 500 largest companies in the United States. This means the fund isn’t tied to a single company or even industry, automatically providing a level of diversification.
Additionally, the S&P 500 index has largely experienced gains over time, typically beating inflation. While all markets fluctuate, over the long-term, gains are more common. Since the creation of the financial markets, the S&P 500 has averaged roughly 6 percent in growth. If you look at more recent times, it may be closer to 10 percent without the reinvestment of dividends. If you are reinvesting your dividends each quarter, these numbers can actually be substantially higher, even reaching into 14 percent territory.
While there are never any guarantees when it comes to investments, most markets trend upward. By selecting the S&P 500 index fund, mitigating risk during low points is easier, and long-term gains are incredibly likely.
An international index fund operates like any other stock-oriented index. However, instead of comprising of US companies, it focuses on international markets.
By adding an international index fund to your portfolio, you achieve an additional level of diversification. Now, your investments aren’t tied to a single country’s economy, which may help should the US experience a financial crisis.
Additionally, international markets may have higher growth potential than the US market, allowing you to achieve more substantial gains. Emerging markets tend to be higher risk but can experience rapid growth as the country or countries continue to develop. Most brokers issue ETFs and mutual funds that track a group of stocks in a specific country or set of countries that are expected to experience high growth.
However, some international markets are also in similar positions to those in the US, so you don’t necessarily have to take on a lot of risk if you want to explore these options.
Bonds are a more conservative investment vehicle, providing the ability to achieve a fixed and predictable income. The concept focuses on being able to access the money on a regular schedule, largely when a bond reaches maturity.
However, you don’t have to invest in individual bonds to get the income-generating benefits. Instead, you can build wealth with a level of diversification by selecting a bond index. For example, an ideal bond fund for some investors may be the VBMFX. That is an index that invests in bonds of from some of the largest and most creditworthy companies in the country. It is similar to the VOO, but better suited to fixed-income goals.
It’s important to note that investing solely in bonds or bond indexes typically isn’t an ideal strategy for investors who aren’t retiring in the near future. Bonds increase in value at a slower rate when compared to stock, making them less suitable for key growth periods in life.
Ideally, you want to find a balance that meets your needs, goals, and expectations, investing some in stocks and some in bonds. Where that point lies will also depend on your risk tolerance. Some may be comfortable with 80 percent in stocks and 20 percent in bonds while others may find a 60/40 split to be a better approach. In the end, you have to choose a percentage that’s right for you, and there isn’t a magic number the guarantees success.
Real Estate Investment Trusts (REITs)
Real estate is an excellent diversification source. Buying a property can be riskier than some other investment vehicles, but it may also provide opportunities to make much higher returns than paper asset markets (VOO), including in the 20 to 25 percent range.
The large return is the result of selling the asset once market prices increase after 3-10 years. However, incidents like the recent housing market crash in 2008 can occur again, leading to low returns or even losses.
REITs or real estate investment trusts, provide a way for retail investors to invest real estate without actually purchasing property themselves. This can lower the cost of entry into the real estate space as well, as you don’t have to buy an entire property on your own. Essentially, these funds pool capital for real estate investing, collecting money from a variety of investors.
REITs should pay around a 10% dividend because they need to pay out at least 90% of their income as dividends. If you have less than $100 to invest, REITs may be a great option for you.
Bonus Investment Approach: Dollar Cost Averaging
Dollar cost averaging isn’t an index fund, but an approach to investment that can help you accumulate wealth. It involves investing the same amount of money into an index on a set schedule, usually monthly or every two weeks.
The approach tends to be more effective than attempting to time the market, an approach that many consider to be more of a myth than a legitimate technique. For example, if you hold all of your money and try to invest it all on an annual basis, if there is a subsequent crash, you’ll likely experience heavy losses. However, by regularly purchasing shares regardless of whether the index is up or down, you hedge some of that risk.
Ultimately, investing in indexes is a smart move if you want to maintain a diversified portfolio with greater ease. Plus, it’s an option available to anyone, making it ideal for new and seasoned investors alike.
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