How to Index

Yesterday, DIY Investor argued that one of the keys to figuring out how to invest is to look at how the experts invest. DIY Investor looked at and presented some evidence on the extent to which some of the nation's largest pension funds index the assets they manage. He noted that, although they are well positioned to find superior performers with their well paid, highly educated advisors and staffs, they invest the bulk of their assets by indexing. In other words, they seek to achieve close to the return on the market. They aren't out there trying to find the  market beaters with the bulk of their assets. This sends a powerful message in favor of the indexing approach - to DIY Investor as well as to many others.


So, how can the average investor index? How hard is it? Do you need to hire an advisor? DIY Investor is a bit battle weary because he has been battling on other sites those who claim indexing is complicated. Here, DIY Investor will show that it is fairly easy and support his thesis that many people, although admittedly not all, can do their own index investing.

Many people confuse investing with  financial planning. Let's be clear, from the start, on the difference between the two. Financial planning is complicated. Financial planning is a road map to guide you over a number of years on your financial journey.  Figuring out the amount to save to reach a target, along with assumptions about life expectancy, inflation, and market returns, is complicated. Understanding the tax implications of various transactions, how to finance a college education, how to title inherited IRAs, and so forth is all very complicated. Getting started on the road to estate planning, as a good financial planner will do for you, is complicated. All of this  is financial planning. Depending on where you are in life, it may very well pay for you to get a financial plan done. And, financial plans are fairly expensive - on average a good plan costs about $2,700.

One of the outcomes of a well done financial plan is an asset allocation. This is where the investing part starts. To be clear, you don't need a financial plan to get an asset allocation; but a good financial plan will produce an asset allocation. To get an asset allocation by itself is not overly difficult and will be discussed in a future post.

For our purposes here, DIY Investor will assume that we have in hand an asset allocation. Again, note that this is the point where we separate with the financial planning firm. At the end of the presentation, they make the pitch to manage the money by arguing that it is complicated and that they only charge 1% of the market value of the assets. DIY Investor politely declines. If they start whipping out charts and talking about how they are great stock pickers and/or market timers, DIY Investor puts his hand on his wallet and runs for the door.

Now we are on the street, breathless, with asset allocation in hand:

Adapted From Schwab

It looks something like this. This is basically an 80% Equity/20% Fixed Income allocation. The percentages represent the target percentage for each asset class. Thus, 20%, for example, is targeted to the international equity class. This allocation wraps up a lot of what the planner found out about you. It takes into account your retirement goals, the number of years until you retire, how you are expected to respond to the ups and downs of the market, and both your need and capacity to take risk. It is one of those areas in which you should feel free to ask a lot of questions.

Investing

The next step is to get actual investments to implement the allocation. To begin, visit the iShares site .  Next put your cursor on the "iShares ETFs" tab, and from the drop down list, click "Core Solutions."  Scroll down and find:

CLICK TO ENLARGE For the "Newbies," the capital letters are ticker symbols. IVV is a "Large Cap Equity" offering, and it fits the bill for the first asset class. Note also that the expense ratio is only .09%. The average actively managed fund charges approximately 1.4%!

So go to Yahoo! Finance and put in the ticker symbol IVV, and find the price of $133.62/share. Assume your portfolio is $1.0 million. The asset allocation specifies 45% in large cap equity, i.e. $450,000. Divide $450,000 by the price of $133.62/share, and you find that you need to buy approximately 3,300 shares of IVV.

If at this point you know how to find prices of ETFs, have a discount brokerage account, know how to execute a trade, and followed the simple arithmetic above, you are good to go. If, in fact, you have a million dollar account, you've probably saved yourself at least $10,000/year in investment management fees.

An unabashed plug: for those who find this approach worth pursuing and yet don't feel quite up to getting it off the ground, I offer, at a reasonable fee (.4% of assets), to get it going by managing it for several months. This gets the initial set-up done, makes sure investments are located properly, and  goes through the rebalancing process. Once they feel comfortable, they can take over the controls on their own.  For those with a bit more experience, I  offer hourly consulting to talk them through the process on the phone or sit down with them as they execute their trades.

An additional point:  some brokers sell commission-free ETFs. These are very convenient for rebalancing - a subject DIY Investor will discuss in the future.

DISCLOSURE:  DIY Investor may own some of the ETFS mentioned here. This information is for educational purposes only. Individuals should do their own research and consult an advisor before investing.