A comprehensive guide for beginner DIY investors
Updated: Jul 7, 2020
With the rise of low-cost index fund ETFs and online brokerages, there has never been a better time to be a DIY index investor. The issue holding many would-be investors back is they don’t know where to get started.
To get started and become a successful DIY index investor, you simply need to know a few basics.
The difference between good index funds and “fake” index funds
Whether or not it makes sense for you to use a robo-advisor or go the pure DIY route.
How to figure out your risk tolerance and set up a risk-appropriate portfolio.
How to diversify your investment portfolio.
Which online brokerage to pick.
How to actually buy index funds.
This post dives deep into all of these issues and serves as a beginner’s guide to getting started as a DIY index investor.
What are index funds and ETFs?
Let’s start with some basic terminology.
Index funds are funds that replicate an index of assets like stocks or bonds. For example, an S&P 500 index fund replicates the S&P 500 index, which is a list of the 505 largest companies in the U.S as measured by their market capitalization.
ETFs or Exchange Traded Funds are investment funds that can be bought and sold on stock exchanges in the same way as individual stocks.
What is the difference between index funds and ETFs?
Many people think that index funds and ETFs are the same, which they are not.
Index funds are defined by their passive investment strategy of replicating a particular index of assets.
ETFs are defined as a specific structure of an investment fund.
Not all Index funds are ETFs, and not all ETFs are index funds.
Many index funds are not ETFs but structured as traditional mutual funds. This means they are not bought on stock exchanges but directly through investment fund companies.
Many ETFs do not follow an indexing strategy. This means they have active fund managers picking and choosing assets rather than following a passive investment strategy.
It is essential to understand the critical differences between index funds and ETFs. However, for the purposes of this article, when I refer to “index funds,” I am referring to ETF index funds. Since this is a guide to becoming a “DIY index investor” and ETF index funds are much more accessible compared to index mutual funds, this is a guide specifically about investing in ETF index funds.
Index funds do not refer only to stocks
When many people hear the term “index fund,” they think of an index fund that tracks the stock market. However, there are index funds that track many different asset classes. The two most popular asset classes for index investors are stocks and bonds, so we will focus on those assets for the remainder of this article.
Not all index funds are created equal
One of the most important things for any new investor to know is that just because an ETF is called an “index fund” does not mean it is a good investment.
There are more indexes and index ETFs than I could ever keep track of. Let’s simplify things by separating index funds into two categories.
Broad-based index funds.
Niche index funds.
Broad-based index funds invest in all or most of a particular asset class in a specific geographic region. An S&P 500 index fund, invests in the majority of the U.S stock market.
Niche based index funds invest in “alternative” assets and subsections of a broad-based index. For example, you could invest in an index fund that tracks an index of technology companies.
Niche index funds by their nature are much more concentrated than broad-based index funds and therefore have a higher variance in possible outcomes. They could do great, or they could do terrible.
There are two types of risk investors have to be aware of.
Systematic risk is the risk that the entire economy and stock market will experience a downturn. Systematic risk is something anyone investing in the stock market accepts. They accept this risk because the expected (not guaranteed) outcome of investing in stocks is positive. This is where the term “no risk, no reward” comes from.
Idiosyncratic risk is the risk that an individual company (for those who pick stocks) or a specific sector (for those who choose niche index funds) is a risk that is specific to that individual stock or sector.
For example, if you invested in a technology index fund, you would be exposed to the broader stock market risk and risks that are specific to the technology industry.
Idiosyncratic risks can be managed through proper diversification. By proper diversification, I mean investing in broad-based index funds that are diversified by asset class and geography (more on that later.)
If your goal is to maximize risk-adjusted expected returns, broad-based index funds make much more sense than buying niche index funds.
Why invest in index funds at all?
While this article is dedicated to understanding “how” to invest in index funds, it’s worth discussing “why” someone would invest in index funds.
To put it in the simplest terms, index investing is the simplest, lowest cost, most rational way for the majority of people to invest their money.
Using equity index funds as an example, investing in a total stock market index fund is the simplest way to invest in stocks. You don’t need to know a lot about finance or think about what you’re invested in.
If you buy a total stock market index fund, you’re invested in every single company in the stock market. If someone were to ask you what stocks you’re invested in, your reply would be “all of them.” It does not get any simpler than that.
Index funds are the cheapest way to build a diversified investment portfolio.
Buying individual stocks typically comes with high transaction costs.
Buying an actively managed investment fund comes with annual investment fees known as Management Expense Ratios (MER), often in the range of 1%-2% of your investments. Meaning if you invested $100,000, you would pay $1,000–$2,000 per year in fees.
Index funds, on the other hand, are incredibly cheap. For example, Vanguard’s S&P 500 index fund has an MER of 0.03%. Meaning if you invested $100,000, you would pay $30 per year in fees.
Index funds are also the most rational way to invest, particularly if you’re investing in stocks. I don’t say this based on my opinion, I say this because it is what the majority of academic research suggests to be true.
Eugene Fama, an Economic professor from the University of Chicago, is best known for his work on the efficient market theory, which states that stock prices are unpredictable and reflect all available information. It should be noted that Fama won the Nobel Prize in Economics for his work on efficient market theory.
If stock prices reflect all available information, and we can’t predict how they will change, it’s next to impossible for investors to outperform the average return of the stock market consistently.
Even if we accept that markets are not perfectly efficient, they are efficient enough that 81% of active fund managers underperformed the S&P 500 index over the past five years.
Investing in index funds is simple, cheap, and has outperformed the vast majority of wall street investment fund managers. It sounds like a pretty rational way to invest if you ask me.
Your biggest risk as an index investor is yourself
We’ve talked about systematic risk and idiosyncratic risk. Now it’s time to discuss the greatest investment risk of all; you.
Yes, you are a greater risk to your investments than anything that happens in the stock market or the economy.
Index funds are designed to be passive investments. Meaning you buy index funds and hold them for an extended period of time. That is the right way to invest.
The wrong way to invest in index funds is to be continually buying and selling them based on what you “think” is going to happen in the stock market. Morning start published a report that found investors consistently underperform the funds they were invested in by nearly 1% per year during that time.
The average fund in the study returned 7.05% per year.
Meanwhile, the average investor returned 6.1% per year.
You might think to yourself, how is it possible for a fund to return 7%, but investors in that fund only realized a 6% return?
To understand the answer to that question, think about how many investors behave when things get choppy in the stock market.
The stock market sees a sharp sell-off, like in the 2008–2009 financial crisis. Investors get scared and sell at the bottom. This turns paper losses into real losses.
Then, they sit on the sidelines and watch as the stock market recovers. Since the stock market often recovers faster than the economy, investors miss out on some of the best months to be invested in the stock market.
Once the economy recovers, investors feel “safe” to get back into the stock market, and they buy when prices are high.
In short, many investors sell-low and buy-high, which is the exact recipe to underperform the funds they are invested in.
If you’re saving for a long-term goal like retirement, that is many years or decades away, what happens in the day to day of the stock market should be of little concern. More money is lost in trying and failing to time the market, then in the market declines themselves.
Index funds are passive investments, but only if you treat them that way by buying and holding rather than trying to time the market.
How to properly diversify an index portfolio
When building your portfolio, you’ll want to consider reducing risk through diversification. There are two broad ways to diversify your portfolio.
By asset class.
Diversifying by asset class
Stocks have a higher expected return than bonds but are much more volatile. Bonds have historically been used as a hedge against the risk of a stock market crash.
During the financial crisis, the U.S stock market fell by more than 40%. While during the same time period, bond prices increased.
Having a portion of your portfolio that increases in value during a market crash is one way to reduce your anxiety during times of uncertainty and avoid the “sell-low, buy-high” trap previously discussed.
For most investors, it makes sense to diversify your portfolio between stocks and bonds.
Choosing your asset allocation
One of the most critical decisions a DIY investor makes is how much of their portfolio to allocate towards risky assets like stocks and less volatile assets like bonds.
To determine how much of your portfolio should be in risky assets, like stocks, you need to consider two things.
Your ability to take on risk
Your willingness to take on risk
Your ability to take on risk is determined by how compromised your finances would be if the stock market suddenly crashed. Here are some checkpoints that would suggest you have the ability to take on a lot of risk when investing.
You have 3–6 months in a cash emergency fund.
You have strong job security.
The money you are investing will not be needed for 10 or more years.
You have little or no debt.
Your willingness to take on risk goes back to the issue of behavioral risk. Even if you are in a financial position to take on risk, you may not be psychologically prepared to watch your investments decline by 50% or more over a short period of time. If you have lived through a stock market crash in which you were invested at the time, think about how stressed you were during that period. That is your first data point to help determine your willingness to take on risk.
Vanguard has developed a free tool to helps you answer that question. This risk profile asks you a series of questions, and based on your results, it recommends an allocation to stocks and bonds that is appropriate for your risk tolerance.
Diversifying by geography
The second layer of portfolio diversification is to dedicate a portion of your portfolio in international investments.
If you invest all of your money in a single country and that countries economy suffers, you will have poor investment returns. If you have your money spread throughout multiple countries,
even if one country is underperforming, that might be offset by another country outperforming.
A paper written by Vanguard in 2019 determined that investors who allocate roughly half of their portfolio to international stocks experience the least volatility compared to investors who only invest in stocks in their home county.
Vanguard found the same to be true for investing in global bonds.
This graphic from Vanguard shows the overall volatility of bonds in the U.S, Canada, the U.K, the EU, and Australia.
The results clearly show that a global bond fund that is hedged to a local investor’s currency reduces the volatility of bonds within a portfolio.
How much to allocate towards international and domestic?
The data and the theory demonstrate that it’s probably a good idea for investors to have at least some exposure to international investments. The question is, how much?
One approach to decide how much your investments in stocks should be domestic vs. international is to base it off your home countries’ share of the global stock market.
For U.S investors, that would mean investing roughly 55% of your investment in stocks in the U.S and 45% internationally.
Beware of withholding taxes
An important consideration when investing in international index funds is withholding taxes, which taxes levied by a foreign government when an investor receives dividends from a company in that foreign country.
Withholding taxes vary by asset class and country. It is beyond the scope of this beginner’s guide to dive too deeply into this complex subject. If you want more detail on withholding taxes and how to minimize them, check out this article, I wrote about how Canadian investors can minimize withholding taxes.
Preferential tax treatments of investing domestically
While withholding taxes act as a disincentive to invest internationally, most governments provide tax incentives to invest in domestic stocks.
I am Canadian, so I will review the issue of tax incentives on domestic dividends from the perspective of a Canadian investor. Many other countries, including the U.S, provide a similar incentive to invest in domestic stocks.
When I invest in a Canadian stock index fund in a taxable account, the dividends paid to me are what are called “eligible dividends.” These dividends receive a preferential tax treatment compared to dividends from an ETF that invests in international stocks.
I live in the province of Ontario in Canada, where the highest marginal tax rate is more than 53%. If I am in that 53% tax bracket, I would only pay a 39% tax on my “eligible dividends” I receive from publicly traded Canadian companies. Any dividends I receive from international companies would be taxed at 53%.
If I received $10,000 in dividends from Canadian companies, I would have roughly $6,100 left after taxes.
If I received $10,000 in dividends from foreign companies, I would have roughly $4,700 left after taxes.
This provides a powerful incentive for me to allocate more of my portfolio to domestic rather than international stocks.
How to think about international allocation
Investing internationally provides greater diversification to a portfolio. But, it comes at the cost of withholding taxes and forgone tax incentives from investing in domestic stocks (when held in a taxable account.)
So, how much of your portfolio should be allocated to domestic and international stocks?
There is no one right answer.
If dividends from domestic and international stocks were treated equally, the rational approach for the equity portion of your portfolio would be to invest in one index fund that tracks the global stock market and invests in each country based on that countries share of the global stock market.
Think of this market-weighted approach as the starting point for your domestic vs. international allocation.
Then consider the withholding taxes of investing internationally, which provides an incentive to invest more in domestic stocks.
Then consider any tax incentives of investing domestically, which provides further incentive to invest in domestic stocks.
How much you invest domestically and internationally will depend on what country you live in and how you feel about the incentives I just described.
Robo-advisor or pure DIY?
No matter how much reading and research some people do, they simply don’t feel comfortable managing their investments on their own. If that sounds like you, then perhaps you might consider using a robo-advisor to help you manage your investment portfolio.
A Robo-advisor is an online platform to provide automated, algorithm-driven financial advice. The robo-advisor asks you questions about your goals, your risk tolerance, and other personal financial questions and constructs an investment portfolio for you based on the answers you provide.
Robo-advisors charge an annual fee, typically based on the amount of the assets it manages on your behalf. Whereas a “full-service” advisory firm might charge 1% or more per year, many robo-advisors charge as little as 0.25%.
Like with human advisors, it’s important to do your homework and research different Robo-advisors to find the one that fits your circumstances. Investopedia has put together a list of the most popular Robo-advisors and listed the pros and cons of each.
Working with a robo-advisor can be an excellent choice for someone not comfortable building and managing an investment portfolio but does not want to work with a full-service financial advisor.
Important factors to consider when picking index ETFs
Once you know how much of your portfolio you need to allocate to domestic stocks, international stocks, domestic bonds, and international bonds, the next task for DIY investors is to choose ETFs that are the best fit for their portfolio.
If you are a U.S investor and you need to buy a U.S stock market index fund to satisfy the domestic stock allocation of your portfolio, how do you know which ETF to choose? There is an ever-increasing supply of ETFs that seemingly do the same thing, how can you possibly tell the difference?
Here are three things I look at when considering an ETF for my portfolio.
The Management Expense Ratio (MER).
Fund structure and withholding tax implications.
Let’s briefly review each of these factors so you can understand their importance when selecting which ETFs to buy to construct your portfolio.
Management Expense Ratios
All index funds have one job; to replicate the returns of the index they are designed to track. There are many different S&P 500 index funds, and they all do the exact same thing; track the S&P 500 index.
Even though all index funds tracking a particular index have the same job, they have different fees. Index funds are a commodity product, and the worst decision you can make when selecting index ETFs is paying more fees than you need to.
An ETFs Management Expense Ratio (MER) is a fee you pay to the fund which pays for all the costs of running the fund. MERs are a percentage of the money you have invested in the fund.
Whatever type of index fund I am considering, the first thing I look for is the MER of the various funds that track that index. If I am looking for an index fund that tracks the Canadian stock market, I pull up the various Canadian equity ETFs and start comparing the MER of each fund.
All else being equal, I go with the fund with the lowest MER.
This issue has less to do with the ETF you choose and is more about which online broker you choose to buy your ETFs from.
Some online brokerages charge commission fees when you buy an ETF. These fees can be $5 or more per transaction. If you’re starting out and only investing small amounts of money, these commissions can eat away at your portfolio.
It’s important to find an online broker that charges low commissions for buying ETFs.
Fund structure & withholding taxes
We have already covered the fact that when you invest in stocks in foreign countries, you are likely going to pay withholding taxes on any dividends you receive.
It’s important to consider how the ETF you are investing in is structured as that could open you up to a second layer of withholding taxes, especially for investors outside of the U.S.
Broadly speaking, there are two ways ETFs that invest in international stocks can be structured.
The ETF holds the stocks directly.
The ETF invests in one or more other ETFs that hold international stocks.
As a Canadian, if I want to invest in international (outside of North America) stocks, I have very few choices of ETFs that are traded on the Canadian stock exchange that hold international stocks directly.
Most likely, I’ll need to invest in an ETF listed on the Canadian stock exchange that owns ETFs listed on the U.S stock exchange, which invests in international stocks.
In these cases, I am charged two levels of withholding taxes.
The first layer of withholding taxes is applied by the foreign governments where the companies are located.
The second layer of withholding taxes is applied by the U.S government.
If possible, the goal when investing in international ETFs should be to avoid the second layer of withholding taxes.
What are the most popular index funds in DIY portfolios?
Let me be clear; I am not licensed to give recommendations on specific stocks or investment funds. That being said, I am happy to provide you a list of some of the most popular index funds that DIY investors use to build their portfolio.
Any fund included on the list does not imply an endorsement of the fund, and I have no affiliation with any of these fund companies. This is simply a resource to get you started.
The ticker name for each fund will appear in brackets.
U.S stock market index funds
Vanguard S&P 500 index fund (VOO).
Vanguard Total stock market index fund (VTI).
iShares S&P 500 index fund (IVV).
iShares total stock market index fund (ITOT).
International stock market index funds
Vanguard total international stock fund (VXUS).
Vanguard FTSE Developed Markets fund (VEA).
Vanguard emerging markets fund (VWO).
iShares core MSCI total international stock fund (IXUS).
iShares core MSCI developed markets international stock fund (IXUS).
iShares core MSCI emerging markets stock fund (IDEV).
U.S bond market index funds
International bonk market index funds
Vanguard total international bond fund (BNDX)