If you're an investor who doesn't want to focus on individual stocks, but you also don't want to pay high investment fees, index funds are the smart way to go. However, with so many index funds to choose from, it can be difficult to decode which are the best for you.
With that in mind, here are some of my favorite index funds for 2018, some of which track broad stock and bond indices, and some of which are a bit more focused.
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Warren Buffett's favorite index fund
Warren Buffett has famously said that the best investment most Americans can make is a low-cost S&P 500 index fund that will simply track the market's performance over time. Buffett even went so far as to wager $500,000 of his own money that such an index fund would outperform a basket of hedge funds over a 10-year period -- a bet he handily won.
For the bet, Buffett chose Vanguard's S&P 500 index fund, which is available in ETF form as the Vanguard S&P 500 ETF (NYSEMKT: VOO). The fund charges a low 0.04% expense ratio and invests in the 500 companies that make up the S&P 500 index. This ETF can be an excellent base for any portfolio, and as Buffett describes it, it's a bet on the future success of American business.
Add some variety to your stock holdings, or boost your income
An S&P 500 index fund can be an excellent backbone for your portfolio, but it can still be a smart idea to diversify your stock exposure.
For example, the S&P 500 is made up of the largest U.S. companies, but small companies have the potential to deliver some pretty strong returns over time. So an index fund like the Schwab U.S. Small-Cap ETF (NYSEMKT: SCHA) can give you exposure to this area of the market without picking individual stocks. The fund has a 0.05% expense ratio and invests in a variety of smaller companies, none of which make up more than 0.25% of the fund's total assets.
Or an index fund that focuses on high-dividend stocks can give you additional income, as well as some downside protection, since dividend stocks tend to outperform their non-dividend counterparts during tough times. The Vanguard High Dividend Yield ETF (NYSEMKT: VYM) is an excellent example that invests in about 400 stocks that all pay above-average dividends. Top holdings include Microsoft, Johnson & Johnson, JPMorgan Chase, and ExxonMobil.
There's a big world out there to invest in
The index funds we've discussed so far focus on U.S. stocks, but that doesn't mean that you shouldn't venture overseas with your investment dollars. In fact, I often suggest that 10%-20% of a well-diversified stock portfolio should be allocated to non-U.S. companies.
One excellent way to add some international exposure to your portfolio is the Vanguard FTSE All-World ex-US ETF (NYSEMKT: VEU), which invests in a broad basket of stocks (more than 2,400) from international markets. Top holdings of the fund include household names such as Nestle, Novartis, and Samsung, just to name a few.
The Schwab Emerging Markets Equity ETF (NYSEMKT: SCHE) takes a slightly different approach to international investing. While the Vanguard FTSE All-World ex-US ETF is primarily made up of companies in developed markets, companies based in emerging markets have the potential for some pretty exciting returns. The Schwab Emerging Markets Equity ETF invests in companies based in China, Taiwan, Brazil, India, and other developing economies, and it charges a relatively low 0.13% expense ratio. To be clear, the higher reward potential of emerging-market stocks comes with increased volatility, so an emerging-market fund like this should only represent a small portion of your total portfolio.
What about bonds?
Every properly allocated investment portfolio should have a bond, or fixed-income, component to complement its stock-based investments.
The Schwab U.S. Aggregate Bond ETF (NYSEMKT: SCHZ) has a rock-bottom expense ratio of 0.04% and tracks an extremely broad index of U.S. investment-grade bonds, including Treasuries, corporate bonds, and mortgage-backed securities. This is basically a one-stop bond investment vehicle and yields 2.38% as of this writing.
On the other hand, if your main priority is income, the Vanguard Long-Term Bond Index Fund ETF (NYSEMKT: BLV) is a good way to get a little extra yield from your portfolio. Longer-maturity bonds pay generally higher interest rates than those of shorter maturities, and this ETF yields 3.68%, significantly more than the Schwab U.S. Aggregate Bond ETF. The downside is that longer-maturity bond values are more vulnerable to interest rate fluctuations, so if rates rise, the principal value of your investment could fall.
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Teresa Kersten is an employee of LinkedIn and is a member of The Motley Fool's board of directors. LinkedIn is owned by Microsoft. Matthew Frankel has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Johnson & Johnson. The Motley Fool has a disclosure policy.