The Indexed Diversification Portfolio Builder
Three to five index funds is all the diversification you need.
Building a common stock portfolio, Schultheis emphasizes, can be summed up in one word repeated three times: diversify, diversify, diversify. The simplest approach is a single total-stock-market index fund. But for those who want slightly more sophistication, he recommends dividing stock holdings into three groups -- large company stocks, small company stocks, and international stocks -- and using three index funds to represent each group.
Aggressive portfolios weight these 50/25/25 (large/small/international). Conservative portfolios weight 70/20/10. For investors who want one additional step, each domestic group can be split into value and growth subcomponents, creating a five-fund portfolio: large growth, large value, small growth, small value, and international.
The critical behavioral rule is annual rebalancing. When one asset class outperforms, you sell from it and buy the underperformer to maintain target percentages. This is emotionally difficult -- it means selling what is working and buying what is not -- but prevents the dangerous situation of being overexposed to a single asset class when the inevitable reversal occurs. The result is less portfolio volatility without sacrificing returns.
- Diversification means aligning your investments with the collective creativity of the economy, not depending on anyone's ability to pick individual winners.
- Three to five index funds provide more effective diversification than a cluttered portfolio of dozens of managed funds.
- Annual rebalancing -- selling winners and buying laggards to maintain target allocations -- reduces volatility without sacrificing returns.
- A portfolio is not a space shuttle. Do not let anyone convince you it requires expert engineering.
- Choose Your Portfolio StructureSelect either the three-fund approach (large cap index, small cap index, international index) or the five-fund approach (adding value and growth splits). The three-fund version is simpler; the five-fund version offers slightly more diversification but is not materially superior.Pro tipIf you currently own twelve funds and eight stocks with no coherent strategy, even a single total-stock-market index fund is a massive upgrade. Do not let perfect be the enemy of good.
- Set Your Allocation PercentagesAggressive investors with longer horizons can allocate 50% large cap, 25% small cap, 25% international. Conservative investors or those nearing retirement should weight toward large cap: 70% large, 20% small, 10% international. Choose the mix that matches your temperament and timeline.Pro tipThere is no perfect allocation. The goal is to broadly represent your risk tolerance and time horizon, then stick with it.WarningDo not change your allocation percentages in response to market movements. Changes should only reflect changes in your life circumstances -- approaching retirement, for example.
- Purchase Low-Cost Index Funds in Each CategorySelect index funds with expense ratios at or below 0.25% in each of your chosen categories. Major providers like Vanguard, Fidelity, and Schwab all offer qualifying options. Invest your predetermined allocation percentage in each fund.Pro tipIf your 401(k) does not offer index funds in all categories, pick one or two managed funds per category and stick with them rather than switching. Compare their performance to the appropriate benchmark index annually.
- Rebalance AnnuallyAt year-end, calculate the current percentage each fund represents. If market movements have shifted allocations significantly from your targets, sell from overweight positions and buy underweight positions to return to your original percentages. In taxable accounts, direct new contributions to underweight categories instead.Pro tipIn tax-deferred accounts (IRAs, 401ks), rebalancing triggers no tax consequences. Do it mechanically based on percentages, not based on market predictions.WarningRebalancing requires selling what has performed best recently and buying what has performed worst. This feels wrong emotionally but is mathematically correct.
An investor allocates $40,000 as 60% large cap ($24,000), 25% small cap ($10,000), 15% international ($6,000). After one year, large caps are up 12% to $26,880, small caps up 7% to $10,700, and international down 3% to $5,820. Total is $43,400.
Schultheis describes the inevitable encounter with a Wall Streeter at a barbecue who tells you a single total-stock-market index fund is 'underdiversified.' The proper response is to smile and ask for the potato salad.
Schultheis developed this portfolio construction approach after seeing investors with twelve different mutual funds and eight stock positions who had no idea how their investments performed or fit together. He wanted a portfolio simple enough that anyone could build it, diversified enough to capture global growth, and structured enough to provide a clear rebalancing protocol.