Step 4: How to Buy Index-Based Stock Funds

Before you can do any of this you need to pick a broker and fund an account. So, here???s a useful link!

Ok, now you are ready to start picking Mutual Funds and Exchange-Traded Funds (ETFs). I invest in funds that are linked to indexes (or if you prefer, ???Indices??? I can roll that way too, dog!)

What’s an index? Well, we already know that I don’t like to beat a dead horse, so, if you don’t know what an index is, here???s another useful link! (If you hadn???t guessed, I love the Motley Fool!)

What is an index?

Ok, now that you know all about indexes [indices], I will say I like index-based funds because:

* Fund Managers attempt to “beat” an index (generally the S&P 500) and most of them fail to do so. So if you do as well as the index, you are getting a better return than most managed funds.
* The manager of a fund has to get paid. An index fund does not have a manager, so the expenses on managed funds are generally higher than on index funds.

Want to read more: (Bow down to the Fool!)

Ok, so now you have a clue about what you want to buy, namely: Stock-based index funds. So, you might be thinking, ???Which funds should I buy???? That???s why I like you so much, reader, because you ask such wonderful questions! This brings up the wonderful topic of ???Where to put your money,??? which is otherwise known as: (Drum roll, please)

Asset Allocation!

Scenario #1:

Q: I’m busy, so I only have time to invest in ONE fund, any help?

 

A: If you only get one fund, then I suggest you get a fund based on the S&P 500 Index. Most 401k plans will offer such a fund. These get you ???build-in??? diversity of 500 companies. Some fund ideas are:

* SPY: ETF called Spiders.
* VFINX: Vangaurd’s S&P 500 Fund.

Scenario #2:

Q: I have a little bit more time to devote to investing; do you have any more ideas?

 

A: Sure!

If you do a little research, you will find these categories of options that are labeled “Asset Classes” and funds within each class. Here???s a break down of how I do my Asset Allocation:

US based funds (Domestic)

US Large Company Funds: 20%
US Large Value Funds: 20%
US Small Company Funds: 10%
US Small Value Funds: 10%

Foreign Funds (Overseas)

Foreign Large Funds: 15%
Foreign Large Value Funds: 10%
Foreign Small Company Funds: 10%
Emerging Market Funds: 5%

Q: If this were a pie chart, what would it look like?

A: See below:

pie chart

Q: How do I find good funds of each class?

A: I’m glad you asked. You should do the research and find funds that have a low expense ratio…lower is better, because it is the money you pay to own the fund. Please click here for an explanation of an expense ratio.

(We???re not getting away from the Fool, this time!)

I did a little research (not using my broker, so you can too) and found out that Vanguard has a good link that shows the different funds (ONLY that they sell, of course). This is just an example , not an endorsement of Vanguard Funds:

(Sorry, no Fool, I know you???re sad.)

That is a list of all of their index-funds. If you click on the fund’s link you can find the expense ratio at the bottom of the page. This research will be easier once you have a brokerage account you can do more in-depth research on all available funds, for free, as part of your brokerage account.

Q: I don’t have enough money to invest in all of these funds. Which funds should put my in money first?

A: My method is invest in U.S.-based funds first, and from top to bottom. It took me several years to purchases funds in all of these classes.

Q: Ok, but what happens when the value of a fund within a class exceeds its target allocation?

A: Well, first…THAT GREAT!!! It means that you are making money!!! Don’t worry about it. You rebalance once per year. I keep a spreadsheet in which I enter the total amount of money invested and then calculate the target percentage and compare that to the actual amount of money I have in the fund. If I have too much money in a class, I sell shares of that fund class. If I don’t have enough in a class, I buy more shares of that fund class. I only do this once per year in order to keep my transaction fees minimized.

Q: What is a transaction fee?

A: Every time you buy, sell, or exchange funds, you are charged a fee (these vary by broker and fund).

Q: Do I have to pay taxes when I sell?

A: In a taxable account, YES! That is why tax-advantaged accounts are so cool. And another reason to only rebalance once per year. You really want to hold onto a fund for at least one year, plus one day, in order to ensure your capital gains taxes are at the lower “long-term” rate. (If you make a profit, of course, that???s what capital gains taxes are all about. If you lose money, that???s a whole other proposition, and maybe a topic for another post!, but you don’t pay tax on a loss.)

Q: How much money do I need to start?

A: Good question!! Every fund has a minimum opening investment, generally in the range of $2000 – $3000 dollars. This is an added wrinkle when trying to establish an opening position in a new fund.?? You might have left over money, but not enough to open up a new fund. In that case, the only thing you can do is spread out that extra money in the funds you already own and wait for them to grow. You see, once you have a position in a fund, you can add to it in any amount, small or large. For example, if I already made my initial investment in VFINX for $3000, and I want to add $1000 the next year, I can do that. But, I can’t take that $1000 and invest it in a new fund if the new fund has an initial investment of more than $1000. If you don???t have any funds at all, and you are looking to get your first one, but you don???t have the minimum amount to open that position, you???ll have to either find a fund with a smaller opening investment, or just hold on to that extra money (No, I will NOT buy that 52??? inch plasma!) until you do have enough to get into to the larger ones.

Ok, now we???re cooking with gas!! I???m still learning the next step, so it may be awhile before you get to read it!

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