The three core principles of effective index fund investing

Index funds — a portfolio or group of stocks designed to mimic the performance of existing stock market indexes (^DJI, ^IXIC, ^GSPC) — generally have a 97% chance of outperforming regular markets based on portfolio composition, according to Ferri Investment Solutions CEO Richard Ferri, CFA.

Ferri, the host of The Bogleheads on Investing podcast, joins Yahoo Finance Live to walk through the fundamentals of index investing and creating a long-term investment strategy for one's portfolio.

"The discipline part is to fully implement that and maintain it basically over the rest of your life. There will be times in life where you're transitioning from working to retirement where you may wish to have more say fixed-income or bonds in your portfolio than equity at that point, but those are just adjusting the sales on this philosophy of indexing that you've created," Ferri states. "It is a lifelong investment strategy that works for basically everybody including some of the very largest pension funds out there,"

For more expert insight and the latest market action, click here to watch this full episode of Wealth!

Editor's note: This article was written by Luke Carberry Mogan.

Video transcript

- Well, the journey to building wealth is a long and winding road. You'll come across many different investment opportunities in your lifetime. But one option that stands the test of time are index funds. Now index funds are a group of stocks that aim to mirror the performance of an existing stock market index like the S&P 500. Now they are well known for their low cost and potential for long-term growth. But with so many index funds to choose from, how do you know which one is the right one for your portfolio?

Well, for more on the success behind investing in index funds, I'm joined by Rick Ferri, Ferri Investment Solutions CEO and host of Bogleheads on Investing Podcast. Good to see you this morning. So first want to break down the three steps that you lay out when it comes to how we should approach index investing, the first one being philosophy. Walk us through that.

RICK FERRI: So the philosophy of indexing is broken down into two different paths. You could either decide you're going to outperform the markets and listen to all the pundits talking about how they have the right strategy to do that and they have the right fund to do that. Or you could just throw that all out the window and say, I just want to own the casino rather than be the casino. And owning the casino, we find over very long periods of time outperforms the other way of doing it substantially.

So if you just have a portfolio that just is the total stock market, the total international stock market, the total bond market or something like that, your probability of outperforming what you would have done with active management is about 97%.

- Goodness. 97%. So then once you have your mindset inside of how you're going to approach this, how do you approach the strategy part?

RICK FERRI: So the second part is once you've come to this epiphany that you are going to use indexing because it's in your best interest long term, now you have to look at, how are you going to put your portfolio together? What percent of your portfolio are you going to have in stocks? What percentage are you going to have in bonds? What percentage are you going to have in cash, as your previous guest talked about? And then you have to just say, well, where can I get these stock index funds?

A lot of people have 401(k)s, IRAs, and such, and you're going to look and see if your 401(k) has index funds and which ones are available. So you need to put the portfolio together; a US stock index fund, an international stock index fund, a bond index fund, maybe a municipal bond index fund if you have a taxable account. So the strategy portion is how you construct your portfolio based on what you have available.

- And obviously it can be tough to have that fear of missing out when you see some indexes taking off or you see a particular stock really thrusting an index higher. How should you approach discipline and when is it time to pivot?

RICK FERRI: Well, the discipline portion is being able to maintain the philosophy and the strategy. So you have the philosophy that indexing is in your best interest long term. And then you create your strategy for your portfolio, which is also long term, the asset allocation and the individual funds. The discipline part is to fully implement that and maintain it basically over the rest of your life. Now there will be times in life where you're transitioning from working to retirement where you may wish to have more, say, fixed income or bonds in your portfolio than equity at that point.

But those are just adjusting the sails on this philosophy of indexing that you've created. So it is a lifelong investment strategy that works for basically everybody, including some of the very largest pension funds out there.

- So Richard, given that it is a very competitive space, there are a lot to pick from if people's eyes are starting to glaze over at just how many there are to pick from. What are some of your favorite picks here?

RICK FERRI: Well, I always go with the most diversified lowest cost funds in each category. So there's a lot of them out there, by the way. There's a very competitive market now for index funds. Thanks to Jack Bogle who started this whole industry back in 1976. But Vanguard, which is the company that Jack Bogle started back then has an assortment of index funds, like the Vanguard Total Stock Market Index Fund, which covers the entire US market. The Vanguard Total International Index Fund, which covers the total international market.

And then the Vanguard Bond Index Fund, which covers most of the investment grade US bonds out there. With those three funds called a three fund portfolio, there are about 95% of the way there with your portfolio.

- It's certainly worth keeping in mind when people are sort of chasing after everything, the slow and steady and consistent route seems to be working there with these index funds. Appreciate you taking the time to join us. Richard Ferri, Ferri Investment Solutions CEO, thank you so much.