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Step 5: Build Your Own

IF TARGET-DATE index funds are so great, why buy anything else with your long-term investment money? There are three reasons: By building your own portfolio of index funds, you could potentially lower investment costs, trim taxes, and put together an investment mix that’s less risky or has a higher expected return.

To that end, you might start with three core holdings: a total U.S. stock market index fund, a total U.S. bond market index fund and a total international stock index fund. Total international funds hold stocks from both developed foreign economies and emerging markets. Fidelity Investments and Vanguard Group offer all three funds as index mutual funds. Meanwhile, the three are available as exchange-traded funds (ETFs) from BlackRock’s iShares, State Street’s SPDR and Vanguard. For a list of some of the total market index funds available, click here.

Also consider two alternatives. First, you could combine a total U.S. bond market fund with Vanguard Total World Stock Index Fund. The latter owns both U.S. and foreign markets and is available as both a mutual fund and an ETF. That would leave you holding just two core funds, though perhaps with more in foreign stocks than you like. Second, you might buy Charles Schwab’s total market funds, which have low expenses and no investment minimums. But because the Schwab International Index Fund owns only developed markets, you’d probably want to tack on a fourth fund—one that focuses on emerging markets.

These various total market funds are among the most competitive areas of the index-fund market, so you can now find funds with tiny annual expenses—lower even than those on target-date index funds.

By putting together your own mix of total market funds, you can also reduce your portfolio’s annual tax bill by allocating the bond market fund to your retirement account. That way, you won’t owe taxes on each year’s income distributions. What if that means you end up with part of your total stock fund holdings in a taxable account? That isn’t so terrible: Any dividends and realized gains will likely be taxed at the special low rate on capital gains.

Finally, by building your own portfolio, you can purchase the precise mix of U.S. bonds, U.S. stocks and foreign shares that you desire. Your personal risk tolerance will drive how much of your long-term investment money ends up in bonds. Meanwhile, the split between U.S. and foreign stocks is a matter of considerable debate. Some experts advocate as little as 20% of a stock portfolio in foreign shares, while others go as high as 50%. Whatever mix you settle on, make a point of writing down what percentage of your portfolio is earmarked for each fund. During periods of market turmoil, that written record will remind you of the strategy you settled on in calmer times. It will also help when rebalancing—a topic discussed in step 9.

Do you consider yourself an investment junkie—and hence you’re willing to buy more than just total market funds? It’s time for steps 6, 7 and 8.

Next: Step 6: Fend Off Inflation

Previous: Step 4: Off the Shelf

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