Create an index portfolio with just five stocks

There's an easy way to approximate the index return – or do better

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This morning I wrote about Exchange Traded Funds and index-tracking funds. In this article, I'll show you how you can create your own approximation of the S&P / ASX 200 index.

The ten largest listed Australian stocks constitute over 50 percent of the ASX 200 index. In other words, the remaining 190 companies make up the other 50 percent.

Over the last 12 months, the ten stocks listed below have slightly outperformed the ASX 200 index, falling just 8.7%, while the index fell 10.1% (excluding dividends).

The top ten stocks

So, without further ado, here are the top ten stocks.

BHP Billiton Ltd (ASX: BHP), Commonwealth Bank of Australia (ASX: CBA), Westpac Banking Corp (ASX: WBC), Australia and New Zealand Banking Group (ASX: ANZ), National Australia Bank (ASX: NAB), Telstra Limited (ASX: TLS), Wesfarmers Limited (ASX: WES), Woolworths Limited (ASX: WOW), Rio Tinto (ASX: RIO) and Newcrest Mining Ltd (ASX:NCM).

No real surprises there, right?

Five stocks

You could obviously go further if you wanted to, and select all of the top 20 Australian stocks. That would give you a much closer correlation in performance to the ASX 200 index.

You may also have noticed that the four big banks are in the top ten. Since their share prices tend to be closely correlated, you could choose to select just one or two of the banks, rather than all four. In theory, that means that with just six stocks, you could track the performance of the ASX 200, to within a fairly close range.

You could also choose between BHP Billiton and Rio, so you only have two resource companies, instead of three. This now means that with just five stocks (BHP, Commonwealth Bank, Woolworths, Wesfarmers and Newcrest), you could track the performance of the ASX 200 fairly closely. Over the last year, a portfolio of those five stocks would have returned a negative 13.4%, compared to the index's negative 10.1%.

Obviously, its not perfect, and the less stocks you pick, the less likelihood of tracking the index.

Issues with this strategy

The risks obviously are that other large companies in the index perform very differently to the top ten. They may be in other sectors, such as insurance, media or transport – not covered by the companies not in the top ten. A way to mitigate this risk would then be to select the best stock in some of those industries not represented. Of course, we think you can beat the index by picking great businesses at good prices.

Foolish takeaway

Given the dominance of the Australian stock exchange by the heavyweight miners BHP, Rio and Newcrest, the top four banks, Telstra, Wesfarmers and Woolworths, the performance of the S&P/ASX 200 index is fairly well chained to the performance of these companies.

By investing in just those 10 stocks (or even just five of them), you could create a portfolio of stocks that will fairly closely track the performance of the index.

If you are looking for ASX investing ideas to help you do even better than the index, look no further than "The Motley Fool's Top Stock for 2012." In this free report, Investment Analyst Dean Morel names his top pick for 2012…and beyond. Click here now to find out the name of this small but growing telecommunications company. But hurry – the report is free for only a limited period of time.

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Motley Fool contributor Mike King owns shares in Woolworths and BHP. The Motley Fool's purpose is to educate, amuse and enrich investors. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson. Click here to be enlightened by The Motley Fool's disclosure policy.

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