Build a passive index fund portfolio by understanding fund types, comparing expense ratios, selecting the right funds, setting up automatic investing, and maintaining tax efficiency.
Learn what an S&P 500 index fund tracks (500 largest U.S. companies)
The S&P 500 represents about 80% of the total U.S. stock market value. It includes companies across all sectors and has returned roughly 10% annually over the past 50 years. This is the most popular single index fund.
Learn what a total U.S. stock market fund tracks (3,000-4,000 companies)
A total market fund adds small and mid-cap stocks to the S&P 500 large caps. Small caps make up about 10% of the fund but historically deliver slightly higher long-term returns with more volatility.
Learn what a total international stock fund tracks (7,000+ non-U.S. companies)
International funds cover developed markets (Europe, Japan, Australia) and emerging markets (China, India, Brazil). International stocks outperformed U.S. stocks from 2000-2009 and may lead again. Diversification reduces country-specific risk.
Learn what a total bond market fund tracks (government and corporate bonds)
Bond funds hold thousands of U.S. Treasury, corporate, and mortgage-backed bonds. When stocks dropped 37% in 2008, the total bond market returned +5%. Bonds reduce portfolio volatility and provide income through interest payments.
Compare Expense Ratios
Target expense ratios under 0.20% for all index funds
The best index funds charge 0.03%-0.05%. On a $100,000 portfolio, a 0.03% fund costs $30 per year. A 0.50% fund costs $500 per year. Over 30 years at 7% growth, that 0.47% difference costs roughly $120,000.
Compare expense ratios between ETF and mutual fund versions of the same index
ETF versions often have slightly lower expense ratios (0.03% vs 0.04%). The difference is negligible on small portfolios. Choose the format that fits your investing style—ETFs for flexibility, mutual funds for automatic investing.
Check for any hidden fees: purchase fees, redemption fees, or account service fees
Some mutual funds charge purchase or redemption fees of 0.25%-1.00% on top of the expense ratio. Most index funds from major providers have none, but always check the fee table in the fund prospectus before buying.
Select Your Funds
For a one-fund solution, choose a target-date retirement fund
Target-date funds automatically hold U.S. stocks, international stocks, and bonds in age-appropriate ratios. A Target 2055 fund might be 90% stocks today and gradually shift to 50% stocks by 2055. Expense ratios run 0.08%-0.15%.
For a three-fund portfolio, select U.S. stock, international stock, and bond index funds
A classic allocation: 60% U.S. total market, 20% international total market, 20% total bond market. This three-fund portfolio covers virtually every publicly traded stock and bond in the world for under 0.10% blended cost.
Determine your stock-to-bond ratio based on your age and risk tolerance
At 25: 90% stocks / 10% bonds. At 40: 70% stocks / 30% bonds. At 55: 55% stocks / 45% bonds. More aggressive allocations have higher expected returns but bigger drops during crashes. Match your allocation to your sleep-at-night factor.
Determine your U.S. versus international stock split
The global stock market is roughly 60% U.S. and 40% international. Common allocations range from 70/30 to 80/20 U.S./international. Tilting toward U.S. has worked well recently, but a 30%-40% international allocation provides important diversification.
Set Up Automatic Investing
Schedule automatic purchases aligned with your paycheck dates
If you're paid biweekly, set automatic investments for the day after payday. Investing $250 every 2 weeks totals $6,500 per year. Tying investments to income ensures you invest before spending.
Start with whatever amount you can afford consistently
Even $50 per month invested in an S&P 500 index fund at 10% average annual return grows to $113,000 over 30 years. Starting small and staying consistent matters more than starting with a large amount.
Increase your automatic investment by 10%-20% each year
Bumping from $250 to $275 per paycheck (a 10% increase) adds $650 more per year. Timed with annual raises, this feels painless. After 5 years of 10% annual increases, you'll be investing nearly 60% more than when you started.
Reinvest all dividends automatically
Dividend reinvestment turns cash distributions into additional shares. Over 30 years, reinvested dividends can account for 40%-50% of total returns. All major brokerages offer automatic dividend reinvestment at no cost.
Rebalance Your Portfolio
Check your actual allocation against your target once or twice per year
After a strong stock rally, your 70/30 stock/bond target might drift to 80/20. Annual rebalancing (selling stocks, buying bonds to return to 70/30) keeps your risk level consistent with your plan.
Rebalance by directing new contributions to underweight assets
Instead of selling overweight assets (which can trigger taxes in taxable accounts), direct your next few months of contributions entirely to the underweight fund. This rebalances without selling, avoiding capital gains taxes.
Use a 5% threshold rule: only rebalance when allocation drifts more than 5 percentage points
If your target is 70% stocks and it drifts to 73%, don't bother. If it hits 76% or higher, rebalance. This threshold approach reduces unnecessary trading while keeping your portfolio close to target.
Maintain Tax Efficiency
Hold bond funds in tax-advantaged accounts (IRA, 401k) when possible
Bond interest is taxed as ordinary income (up to 37%). In a Roth IRA or 401(k), that interest grows tax-free. Holding bonds in taxable accounts while stocks are in tax-advantaged accounts is backwards and costs you more.
Hold stock index funds in taxable accounts for favorable capital gains treatment
Long-term capital gains rates (0%, 15%, 20%) are lower than ordinary income rates. Index funds are already tax-efficient because they rarely sell holdings. A typical stock index fund distributes less than 1% of its value in annual capital gains.
Use tax-loss harvesting in taxable accounts during market drops
If your total market fund drops 15%, you can sell at a loss and immediately buy a similar (but not identical) fund. The loss offsets up to $3,000 in ordinary income per year, saving $660-$1,110 in taxes at the 22%-37% bracket.
Avoid frequent trading in taxable accounts to minimize tax events
Every sale in a taxable account is a potential taxable event. Index fund investors who buy and hold for decades may never sell, deferring all capital gains until retirement when they may be in a lower bracket.
Frequently Asked Questions
What is the difference between an index fund and an ETF?
Both track the same benchmarks. ETFs trade intraday like stocks; mutual funds trade once daily after close. ETFs tend to have slightly lower expense ratios and better tax efficiency. Mutual funds allow automatic dollar-amount investments. For long-term investors, performance differences are negligible.
What expense ratio should I look for in an index fund?
Target below 0.10% for broad market funds. Top S&P 500 funds charge 0.015-0.03% (Fidelity FXAIX, Vanguard VOO, Schwab SWPPX). On $500,000, the difference between 0.03% and 0.50% is $2,350/year, compounding to over $100,000 lost over 20 years.
How many index funds do I need for a diversified portfolio?
A three-fund portfolio (US total stock, international stocks, US bonds) provides full diversification. More than 5-6 funds adds complexity without meaningful benefit since broad funds hold thousands of securities. Simplicity reduces behavioral mistakes.
Should I invest a lump sum or dollar-cost average into index funds?
Vanguard research shows lump-sum outperforms DCA two-thirds of the time since markets trend upward. If the amount exceeds 20% of your net worth and market drops would cause stress, splitting over 3-6 months is a reasonable compromise.