Building a low cost investment portfolio of Index Funds

Tracking an investment portfolio of index fundsAt the core of my plan for gaining Financial Independence will be an investment portfolio consisting of low cost passively managed index funds. Index funds basically aim to track the performance of the stock market. They are not actively managed funds which aim to beat the market and can be very costly.

Here I will outline the steps to take in order to construct an efficient, low maintenance, passively managed investment portfolio. My own portfolio is based on this strategy. The portfolio has managed an annualised return of about 15% since inception in June 2014.


Step 1 – Determine your asset allocation

Asset allocation is the proportion of stocks to bonds within the portfolio. Stocks are riskier than bonds and consequently have a higher return. The general rule is to allocate your age in bonds so that your portfolio will become less risky as you approach retirement. For example, a 35 year old will have a portfolio consisting of 65% stocks and 35% bonds. This can be adjusted according to your risk tolerance.

My portfolio is on the aggressive side and has a 80% stock and 20% bond mix. The charts below show comparisons of 50% stock/ 50% bond with a 80% stock/ 20% UK based portfolio. A 15 year period from the year 2000 is used. A useful tool for determining asset allocation according to age and risk tolerance is available here

50% Stock 50% Bond Portfolio performance graph

Conservative 50% Stock 50% Bond Portfolio

80% Stock 20% Bond Portfolio performance graph

Aggressive 80% Stock 20% Bond Portfolio

The more conservative asset allocation was affected less by market downturns and had lower volatility but had lower returns over the long term. During the worst year (2008) the 50/50 portfolio lost about 12% compared to 23% for the 80/20 portfolio.

However, investors in the 80/20 portfolio could have taken advantage of low prices to buy more stocks in 2008 and seen bigger gains in 2009. As Warren Buffet said “Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down.”

Step 2 – Identify an investment platform with low management fees

An investment platform or fund supermarket enables you to find and purchase a wide range of investment products. Some platforms also allow the purchasing of single company stocks. A number of platforms are available which have different fee structures depending on aspects such as total value of investments held and type of investments.

It is crucial to identify the lowest cost platform according to your situation and hold the lowest cost funds on it. The amount of platform and fund fees can have a dramatic impact on overall returns over a long period as shown in the illustrations below. Over 25 years an investment with high charges of 2.51% will lose over half of its returns while a lower cost investment of 0.39% will lose just 10%.

Graph showing the impact of expenses on a high cost investment portfolio

Impact of expenses on a high cost investment portfolio

Graph showing the impact of costs on a low cost investment portfolio

Impact of costs on a low cost investment portfolio

Step 3 – Buy funds funds to suit asset allocation and diversification targets

Asset Allocation

Once the investment platform is chosen, the next step is choose the appropriate funds according to asset allocation. I use and recommend Vanguard index funds because they are usually the lowest cost funds, are able to closely track their respective stock indices and I believe in Vanguard’s principles of valuing the investor. Since 1976, fees on Vanguard funds have gone down to 0.12% from 0.70%. In comparison, fees across other mutual funds are typically around 1%. A video demo showing how index funds can be found and analysed can be viewed on my Youtube channel here.


Diversification

Diversification of the portfolio is important because it ensures that when one particular asset is underperforming, overall portfolio performance would be impacted less. In addition, diversification allows the capturing of higher returns of an asset which would otherwise have not been held. My principle is to diversify globally by holding funds that generally represent the global economy. This is referred to as a slice and dice portfolio. My target allocations are shown in the following table.

FundTypeAllocation
USA index fundStocks30%
UK index fundStocks15%
Developed Europe index fundStocks15%
Japan index fundStocks10%
Pacific ex-Japan index fundStocks10%
UK government bond index fundBonds 20%

Step 4 – Make regular contributions to portfolio

The final step is to make regular contributions (dollar or pound cost averaging) by buying the your chosen funds in their proportions. I recommend doing this monthly by setting up a monthly savings plan. Investment platforms allow this to be done, automating the whole process. Plan ahead to determine how much you can invest per month and adjust the payments accordingly.

Once the portfolio is up and running it will need to be rebalanced when needed to maintain the target asset allocation. That will be the subject of other posts.

Above are the simple steps that I have taken to build an investment portfolio of index funds that is easy to maintain and has relatively high returns.


Image courtesy of Luis Llerena at unsplash.com/@albertosaure

Calculators and charts courtesy of: Vanguard Tools at https://www.vanguard.co.uk/uk/portal/investor-resources/learning/tools 

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