Index investing involves investing in a portfolio of securities that are contained within an index, like the Dow Jones Industrial Average (the DOW). The DOW is a set of 30 very large companies and the index tracks the value of those 30 companies. The S&P 500, another popular index, consists of 500 large mostly U.S.-based companies. If you owned all 500 companies of the S&P 500 you would have a more diversified portfolio of stocks compared to owning only stocks in the 30 companies that comprise the DOW. However, even owning all of the S&P 500 is not going to get you a well diversified portfolio. There are many, many indexes, but the DOW and S&P 500 are two of the most well-known as they are among the oldest indexes and contain very large U.S. companies.
To have a well diversified stock portfolio you need to invest in companies of all sizes (market capitalization), in all the major sectors, and in all the major (and minor!) markets of the world. Thankfully, it is very easy to do so nowadays. You can do this via exchange-traded funds, or ETFs. ETFs typically have very low management fees. And, some brokerage firms let you trade a limited set of ETFs without a commission. This post explains how to form a well-diversified equity (stock) portfolio that includes companies from all over the world by purchasing either two or four ETF commission free. At the time of this blog post, the total cost for all four ETFs is less than $500.
Open a Brokerage Account
The first step is to open a brokerage account. I happen to use TD Ameritrade so that is the one I will discuss because I am familiar with it. As far as I know, TD Ameritrade does not require a minimum amount to open an account. Create an account and transfer $500 to it (although you can do this process in stages with even less than $500). TD Ameritrade offers commission-free trading for 100 ETFs, including the four I am suggesting below.
To open account on TD Ameritrade, click on OPEN AN ACCOUNT in the upper right corner of TD Ameritrade's home page. You'll need a few bits of information, including a social security number (or tax ID number). You will need to choose an account type. I've included a screen shot of the most common account types below.
Why does this matter? It will impact whether or not you have complete access to withdraw/add funds at any time. If you open an IRA the amount you can add each year is limited and subject to a specific set of restrictions. One big restriction is that you must generate EARNED income (as recognized by the IRS) and the absolute max you can contribute annually (as of 2017) is $5,500 if you are under 50 years of age. You can also only withdraw money from an IRA for very specific reasons. If you want unlimited access to your money and the ability to add/withdraw with no legal restrictions based on tax laws, you should open an Individual account (or Joint, if you are opening an account with another person). Make sure you read about each type of account. When you click on an account type the verbiage to the right will describe the account type.
You will also need to choose whether you are going to actively trade stocks and other securities or only occasionally trade stocks, mutual funds, ETFs or bonds. If you are new to investing (and I am presuming you are because you are reading this post), choose the first option.
Complete the account opening process and transfer funds to the account. To purchase all four securities I am recommending, you will need about $500 at the time this post was written.
Enroll in Commission-Free Trading
With TD Ameritrade you have to sign-up for their commission-free trading. It's free and I am not sure why they make you register for it, but you must for your trade to actually be commission free. To access the commission-free ETF trading platform, after you login to your TD Ameritrade account, you should click on the RESEARCH AND IDEAS menu. It is under the ETFs section as shown in the screenshot below.
Clicking COMMISSION-FREE ETFs will take you to this screen:
Once you are enrolled in their commission-free program, you should see the "Congratulations! You are enrolled in commission-free ETFs." That will allow you to trade any of the ETFs from the commission-free list free of charge. Otherwise, you will have to pay a commission of $6.95 for every ETF trade you make.
Buying ETFs
Now it is time to actually purchase your ETFs. I am going to recommend four, but you do not have to purchase all four.
- First I would purchase VTI. Vanguard Total Stock Market ETF invests in the stocks of about 3,500 publicly-traded corporations based in the U.S. About 72% of the companies are classified as Giant or Large Caps, 19% as Mid Caps and 9% as Small or Micro Caps. It is a broad, passively-managed index fund that diversifies the investor across U.S. publicly-traded corporations.
- Next, I would add some foreign stocks to diversify my portfolio, in the form of shares in VEU. Vanguard FTSE All-World ex-US Index Fund ETF invests in stocks of mostly larger publicly-traded corporations across the world (except the U.S.). At the time of this writing, VEU owns stocks in about 2,500 corporations, including Nestle, BP, Bayer, Toyota, Unilever and Anheuser-Busch. The majority of the stocks are from Giant or Large Caps (about 90%) and the remainder are Mid Caps. This ETF will diversify the investor in terms of foreign equity investments, although it does not contain any significant amount of Small Caps.
- Third, I would suggest adding some foreign Small Caps via VSS--Vanguard FTSE All-World ex-US Small-Cap Index Fund ETF. VSS invests mostly in Mid Caps non-U.S. stocks (66%) and about 34% in Small and Micro Caps. The fund owns stock in nearly 3,400 smaller publicly-traded corporations that you would probably not recognize. I suggested adding this fund because VEU does not contain any small caps and adding foreign small caps will boost the diversification of your portfolio.
- Finally, if you want to add some more Small Cap U.S. corporations, you could buy some shares of VB--Vanguard Small-Cap Index Fund ETF which owns stock in about 1,500 smaller publicly-traded corporations based in the U.S., including Domino's Pizza, JetBlue Airways and Vail Resorts. VB is made up of about 58% Small and Micro Caps and 42% Mid Caps.
If you bought all four of these ETFs, it would give you a diversified portfolio of domestic and foreign equities. You would indirectly own shares in about 11,000 publicly-traded corporations of all sizes across the world. You would be invested in every sector of the market, as well. Learn about different ways to classify stocks (by company size and geographic region or by sector and type of market).
How Many Shares Should I Buy?
You cannot purchase less than one share of an ETF. I am writing this post for people who do not have a great deal of money to invest so I am going to assume that you will probably only purchase one share at a time. That is the main reason the "commission-free" nature of this strategy is so important. Right now the cost of one share of VEU is about $50. If you had to pay a $6.95 commission to buy one share, that is a hefty fee to pay relative to the price of the ETF.
Here's my recommendation. First buy one share of VTI. It currently costs about $125. If you just did this and nothing else, you would own a portfolio that is nicely diversified across 3,500 publicly-traded U.S. corporations. My next recommendation would be shares of VEU, but VEU only costs about $50 per share. If you bought one share of VTI and one share of VEU, it would cost about $175, but VTI (U.S. stocks) would be a greater proportion of that $175 (VTI would be $125/$175 or 71%) and VEU (foreign stocks) would be 29%. So I would buy TWO shares of VEU for a total cost of $100. That would bring your portfolio up to $225, with VTI being $125 of the $225 (56%) and VEU being 44% (or $100/$225). You do not have to buy all three shares the same day. You could buy one share of VTI today, next month buy one share of VEU and the following month another share of VEU. Just note that the prices of the shares change over time (although not necessarily by HUGE amounts from day-to-day). Finally, after you have bought those three shares, add one share of VSS. Then, if you want to add even more Small Cap U.S. stocks you could add some VB. However, because the price of VB is about $135, buying one share in conjunction with the few shares you own of VTI, VEU and VSS will really boost your proportion of Small Cap U.S. stocks. You should be aware of this because Small Caps are generally a riskier subset of stocks.
As time passes and you want to add more money to your portfolio, I would continue investing in this order: VTI, VEUx2, VSS, but no more VB this rotation. I would only buy more shares of VB maybe every third rotation. I'll explain how to evaluate your entire portfolio in a bit and you will see why.
How Do I Actually Purchase Shares?
To purchase your share (or shares) in specific ETFs, after logging into your TD Ameritrade account, click on RESEARCH AND IDEAS, then COMMISSION-FREE ETFs as I showed above. At this point, you will see four tabs under the "Commission-Free ETF List"--Category, Fund Family, Market Cap and All Funds. You should be on the FUND FAMILY tab which organizes the commission-free ETFs by the investment company that manages them. Click through to VANGUARD. See the image below.
Note two things: First there is a second page and you will have to go to the second page to access VTI. To access the second page, scroll to the bottom of the list and click NEXT.
The second thing to notice is there is a link to the right of each ETF that says Buy or Sell. Since you want to purchase a share of VTI, click on the BUY link. It will open a small trading window on the bottom of your screen that looks like this:
Under QUANTITY enter 1 (or more, if you want to purchase more than one share at a time), and under ORDER TYPE select "Market." Your screen should show this:
Click REVIEW ORDER to see the following screen:
Make certain you check the "Estimated total" amount because that is about how much your order will cost and you need to have at least that much in your account available for trading. If everything looks correct, press PLACE ORDER. Your order will be placed when the stock market is open for trading. If the market is open when you place your order, the order will occur within a minute or so.
Follow the same steps to buy the other ETFs.
Analyzing Your Portfolio
As you add more shares to your portfolio, it is good to know how diversified it is. If, for example, you own one share each of VTI and VSS along with two shares of VEU and you decide to add one share of VB, how does this impact the overall make-up of your portfolio in terms of foreign vs. domestic stocks, and Giant vs. Large vs. Mid vs. Small vs. Micro Cap stocks? Morningstar.com offers a free Instant X-Ray that shows how your portfolio is allocated. For instance, if you own one share of VTI, two shares of VEU, one share of VSS, and one share of VB, you would enter the following information into the X-Ray, your portfolio's total value would be $467.01 based on the following prices for each ETF as of 7/10/17:
You can track the value of your portfolio on Morningstar or Yahoo! Finance, among others. Entering the ETF's "Ticker Symbol" and the Total Value into the X-Ray as shown below:
and clicking SHOW INSTANT X-RAY results in the following output.
Examining your X-Ray as you add more shares is helpful to ensure that your portfolio's asset allocation (the balance of foreign vs. domestic stocks and different sized companies, etc.) is right for you.
Recommended Reading
For new investors a book I strongly recommend is The Bogleheads' Guide to Investing. It covers the basics and explains the reasoning behind diversification. It discusses stocks, bonds, mutual funds, ETFs, fees and taxes among other things. It's the book I require for the Personal Investing course I teach and the one book on finance I really hope my kids read.
Other Recommended Portfolios
Paul Merriman, a respected financial adviser (now retired), offers a recommended list of commission-free ETFs that form an even more diversified portfolio than the one I have suggested. He offers a specific recommendation for commission-free ETFs available on TD Ameritrade.
