- 1). Choose your fund type. The first index funds were the more traditional "open-end" mutual funds, which do not trade on an exchange but rather are issued and managed by individual fund companies. Unlike open-end funds, exchange-traded funds, or ETFs, can be bought and sold throughout the market day and purchased in the open stock market. While you can certainly build a portfolio combining both open-end funds and ETFs, you should research the pros and cons of each to see which might be more appropriate for your investment needs. For example, while you can trade ETFs more readily than open-end mutual funds, there may be more expenses involved, for trading commissions or annual expenses.
- 2). Build an asset allocation. Based on your personal investment objectives -- for example, growth, income or a combination of both -- you should select funds that have similar goals. Unless you intend to own only a broad-market index fund, such as one that tracks the Standard & Poor's (S&P) 500, you should consider diversifying your index funds. Fortunately, index funds lend themselves to being components of an overall asset allocation. For example, with just a few purchases, you can own a financial services index, an oil and gas index, a gold index, a pharmaceutical index and a technology index, and you will instantly have a good level of diversification in your portfolio. One common investment strategy involves buying a "core" fund, such as a general market index fund and complementing it with one of these industry-specific funds.
- 3). Consider your tax situation. Some funds are notorious for making year-end taxable distributions. If you aren't prepared for these, they can sting if you own them outside a tax-advantaged retirement account. Additionally, if you are going to be trading your index portfolio, you may trigger a number of short-term gains, which are taxed at the more unfavorable regular income tax rates, as opposed to the longer-term capital-gains tax rates. The same tax traps await regular equity investors, but you should be aware that you are not immune to them simply by investing in an index fund portfolio.
- 4). Prepare for volatility. While a well-diversified index fund portfolio may trade fairly steadily as a unit, the individual components can be highly volatile. Remember that each index fund may be concentrated by industry, so when things go bad for that industry, they tend to go bad for the index as a whole. By constructing a well-balanced portfolio, your overall investment plan can weather the individual fluctuations, but you should be aware that wild swings are likely over the short term.
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