How to build an investment portfolio of low cost index funds

We all have heard horror stories of relatively inexperienced investors losing out on their precious savings in the investment market. This is quite intimidating and deters the average person from investing altogether.

While there is no denying that there are risks involved with investing and before moving forward, it is extremely important to address the question: why should we even invest in the first place?

The answer to this question is that we are losing our savings gradually without even realising it because of inflation.

According to Investopedia:

“Inflation relentlessly eats away at the value of your money. If costs rise 3% annually, a dollar today will buy only 74 cents’ worth of goods in ten years. Even the most risk-averse investor needs to find a way to at least stay ahead of inflation.”

Hence, it is imperative to invest our money and to get a return which is at least above the inflation rate. However, this is not as straightforward as it seems since it is extremely difficult to beat inflation by parking our hard-earned money in a savings account or a fixed deposit. This leads a person to take more risk in an effort to achieve higher returns.  But where greater risk can lead to a higher return, it can also lead to greater losses.

So this leads us to the second question: how can you invest without losing an arm and a leg?

For the majority of people, investing seems like the exercise of painstakingly choosing individual stocks, monitoring their daily movements and constantly buying and selling them. This is at least how the movies portray it and while you can hire financial advisors to aid you with this or you can seek the help of a professional fund manager, the fact is that the majority of these active investors fail to beat the market.

According to the figures released by Standard & Poor’s, which is widely regarded as the most accurate gauge of the performance of large-cap American equities, almost all US, global and emerging market funds have failed to outperform the market since 2006. In comparison, S&P 500 index has provided an average annualised total return of 9.8 percent over the past 90 years.

Therefore, wouldn’t it be great to achieve the market return with minimal risk? This is possible with index funds...

What is an index fund?

Index funds are fund that hold each and every stock in a particular index like the S&P 500 or the FTSE 100.  This means that rather than attempting to beat the market benchmark, these funds merely aim to mirror the index that they track.

The beauty of index funds is that they have built-in diversification since the investment is spread across all stocks in the index. Furthermore, the fund doesn’t attempt to beat the market; it simply follows the performance of the market.  

Warren Buffett, chairman and CEO of Berkshire Hathaway, also recommends investing in index funds. According to him, "Consistently buy an S&P 500 low-cost index fund. I think it's the thing that makes the most sense practically all of the time." (CNBC: The Money)

The biggest advantages of index funds are:

1)     Low cost: Index funds are low cost because actively managed mutual funds charge higher fees since they employ analysts and managers in an effort to beat the index.

2)     Built-in diversification: As the investment is spread across the whole index, there is in-built diversification in the index fund.

3)     Low maintenance: The index fund only has to mirror the index and hence, doesn’t need to be actively managed. You don’t need to actively track of the market.

4)     Sleep easy investment (low stress): It is the ultimate form of “lazy” investment. You can just invest and forget about it.

5)     Higher return than most actively traded funds: Most active funds fail to outperform the market. Therefore, it makes sense to invest in index funds.  

The UAE index fund

When it comes to index funds, UAE offers an excellent option in the form of Afkar Capital, which was listed as the first foreign exchange-traded fund in the UAE on the Dubai Financial Market in June 2016. The index includes the largest stocks by capitalisation in the United Arab Emirates, and hence, provides exposure to the UAE economy (DFM).

This is extremely attractive if you consider that The Dubai Financial Market has a 5-year average return of around 14%. You must, however consider the fees associated with this investment as they are significantly higher than most.

Moving forward, let’s look at the most important question to be addressed: how do you build an investment portfolio?

The 2 fund portfolio

This is the simplest of the portfolios. If you are invested in an index fund that tracks a stock index, you can achieve further diversification by investing in a broadly-diversified U.S. investment-grade bond index fund, with ideally a 50:50 split between the two index funds.

The primary advantage with this fund is that the stock market and the bond markets have a different set of economic factors affecting them. A certain economic change, say the interest rate, may not be feasible for the bond market but it will provide a boost for the stock market.

As a result, this portfolio will give you diversification not within a certain class but across two of the biggest asset classes that exist in the world.

The 3 fund portfolio

You can take things a notch higher in the two fund portfolio by including an international index fund to the existing portfolio. This adds further diversification to your portfolio and gives you the flexibility to adjust the risk and return profile of your portfolio by adjusting the weights of the portfolio. You can increase the comparative risk by investing more in the international index fund, which may allow you to able to earn a higher return. On the other hand, you can keep it simple and just keep equal weights for each fund or you can keep it absolutely safe by having just 10% of your money invested in the international index fund.

Best buy: Vanguard 500 Index Fund Investor Shares (VFINX)

Vanguard is a multi-trillion dollar investment manager, which due to their size means they can offer a very low expense ratio of 0.14%. As this fund seeks exposure to large-cap US equities, it is most suitable for moderate to high risk investors over the long term.

Looking to start an investment or open a trading account? Check out www.expatsavingplans.com.

Investing may seem like an arduous exercise but if done properly, it doesn’t have to be a troublesome experience. You can build a solid portfolio by using low cost index funds and earn a return that is in line with the market’s performance. To get started, open a trading account or speak to a trusted financial adviser.

Read more: Top 3 ETFs to track the S&P 500

Tags: Investing ETFs