Index Funds and Diversification
I recently had an email from an 18 year old woman that asked me how she should get started investing. Here's what she said:
I just turned 18 years old, and would like to invest young so that I can have life-long investments. I'm interested in investing in somewhere where there will not be outrageously high trading fees or commissions. It would need to be somewhere that can accept a minimum of $1,000 and I am having trouble finding something that works for me. Being extremely new at this, I have no clue how to compare multiple companies, or which company will be the most beneficial in the long run. I was wondering if you had any recommendations or advice for a beginner like me?
Two things stand out in this email. First, she recognizes the importance of investing at a young age. Liked we talked about afew weeks ago - the power of compounding has three ingredients:
(1) the amount of money invested; (2) the annual return; and (3) time. They say that time heals all wounds. I'm not sure if that's true, but it certainly is the fuel that drives the power of compounding.
Second, she recognizes the importance of keeping fees low. Expensive mutual funds or investment advisors, or both, can easily deplete enormous amounts of wealth. It's for this reason that the cost of mutual funds and an investment advisor combined should never exceed 50 basis points (that's one-half of one percent). This of course eliminates most investment advisors from consideration.
So what are her options? How do we find low cost investments with just $1,000 to get started? Fortunately there are several great options.
With technology and computerized trading, the world of investing has changed so much and in so many ways that the skills and concepts of performance investing no longer work. In a profound irony, the collective experience of active professional investors has made it almost impossible for almost any of them to succeed — after fees and costs — at beating the market. The time has come to switch from actively managed funds to low-cost funds.
What is an Index fund? It is a group of investors that participate in a “fund” of money that is used to invest in each of the stocks that make up a sector. For example, if you invest in a Dow Fund, it will buy each of the 30 stocks in an equal amount of money. That way the fund will perform exactly like the market.
These low-cost investments are intended to match the performance of major market benchmarks, like the S&P 500. They offer instant diversification and eliminate the risk of choosing a single stock that turns in subpar performance, as so many do.
But which index funds are best? Not every index fund is appropriate for a small investor’s portfolio. Some have higher fees than others and may carry extra risks because they’re narrowly focused, tracking stocks of a single industry or country. As a result, they could drop in value far more than the overall market.
So here are two questions to answer before investing in an index fund:
Which index should you use? That's a trickier question than you may think, because there are dozens of indexes used by index funds.
Standard & Poors alone has 10 U.S. equity indexes and nine U.S bond indexes.
Which index fund company should you buy from? Because index funds are intended to mirror the performance of their underlying benchmarks, ones based on the same index should have the same performance, before fees. So, all else being equal, when selecting among similar index funds the fund with the least expensive version is best.
Since it can be difficult for new index funds and ETFs to attract
customers, Mosley prefers dealing with established ones. There’s less chance that the fund or ETF with a long track record will shut down due to a lack of investors.
Here are the funds and companies I use or recommend:
The starting point is Vanguard. Founded by John Bogle, Vanguard introduced the world to low cost index mutual fund investing. These funds track various indices such as the S&P 500. They give investors excellent diversification at rock-bottom prices.
Further, study after study after study shows that over the long term, index funds outperform actively managed funds on an after-fee, after-tax basis.Most of Vanguard's funds require a $3,000 minimum investment. One option would be to save up $3,000 and then start with the Vanguard S&P 500 fund (VFINX).
But in answering my listeners e-mail I would suggest the Vanguard Target Date Retirement Fund series which a $1,000
minimum investment . These funds allocate an investor's money into four mutual funds, covering U.S. and foreign stocks and U.S. and foreign bonds. Further, the allocation among these four asset classes gradually changes as the investor nears retirement.
Other Fund Companies
While I'm partial to Vanguard, there are other options with lower minimum investment requirements. For example, the Schwab S&P 500 Index Fund (SWPPX) has an expense ratio of 9 basis points and a minimum investment of just $100.
If you do stray from Vanguard, however, be sure to check the details of the index fund. While these funds generally are less expensive than actively managed funds, some do come with high fees. For example, the T. Rowe Price Equity Index 500 Fund has an expense ratio of 27 basis points – that 3x the Schwab cost. There's simply no reason to pay this much for an S&P 500 index fund.
Now let’s talk a bit about the value of diversification.
You may think that the market will tank because China’s economy is slowing or that gold will skyrocket in value because inflation is due for a spike or that bond yields have nowhere to go but up. But the
market doesn’t care what you think.
You might be right and you might be wrong. A prepared investor will plan for multiple scenarios and focus on what can be controlled.
Since you can’t control or predict what the market will do, you should develop a process and a plan for how you will react, or not react, over time.
There’s no use in beating yourself up about missing out on something that happened in the past. What matters now is what happens in the future. The good news is that factors you can control are often more important than the ones you can’t.
Making the decision to index is half of the task. The other half is deciding on the long-term portfolio mix — stocks vs. bonds and domestic vs. international— that will be best for you. Since a key benefit of Index Funds is easy diversification, make sure any you choose will work toward that goal.
If you want to invest internationally, buy a developed-market international fund like one based on the MSCI EAFE index (MSCI is the company that created the index; EAFE stands for Europe, Australasia and Far East). Stocks of developed markets are less volatile, typically, than those of undeveloped or underdeveloped regions.
I also like using index funds to help you gain exposure to emerging markets. Indexes are a great way to participate in another corner of the world without having to be an expert in any market or region.
Steps to get started:
1. Select a major firm that is a leading index fund and ETF provider charging low fees and oﬀering a range of index funds and ETFs. BlackRock, State Street Global, and Vanguard are the market leaders, and all meet the selection criteria. For index investors, the good news on pricing is that the major providers’ already very low index fund fees continue to come down.
2. If you have an account with a stockbroker, buying index funds in that account is as easy as buying any stock. Your broker will do it for you. You may get some resistance because the broker knows that when an investor moves into indexing, that investor won’t be trading — and generating commissions for him or her.
If you don’t have a Registered Investment Adviser or an account with a stockbroker, you can contact the index fund manager you choose by calling its 800-number or visiting its website. Here are phone numbers for the Big Three: BlackRock, 800-441-7762; State Street Global, 800-997-7327 and Vanguard, 800-252-9578.
Most index investors will find everything involved in opening a new index fund account can be comfortably completed in much less than half an hour and you’ll be on the right track, earning higher long-term returns at lower cost, for years to come.
3. Start by investing in a “plain vanilla” index fund of large and mid- sized company stocks like the S&P 500 (or the FTSE Index) or a total market fund that includes smaller companies. All indexes — and, therefore, all index funds — are dominated by the leading companies.
4. Your next decision is whether to combine your “domestic” index fund with an “international” index fund. (The use of quotes is a reminder that many “domestic” companies like Coca Cola earn a majority of their profits in international markets. And some
“international” companies — like BP — earn most of their profits in the United States.)
About half of the global stock market is U.S. “domestic” and about half is “international,” so if you want maximum diversification, you’ll go 50/50. Markets go up and down differently, so perhaps once a year you may want to rebalance back to your original index portfolio structure. If you use a global index fund (combining both
U.S. and international markets), no rebalancing is called for: it’s done for you.
5. If you prefer less international diversification, limit international to 10, 20 or 30%. Choose whatever feels comfortable to you.
6. Because one of the great benefits of indexing is that it implements your long-term investment policy decisions so effectively, be sure to make only those commitments you plan to stay with for the long term — 10 years or longer. This is savvy self-discipline on your thinking.
You can always change your holdings whenever you have a good long-term reason to change your investment policy.
7. Next, you’ll want to decide on the right percentages of stocks versus bonds for you. You’ll do this just as you would decide if you were still an active investor.
8. One high-grade bond index fund and one index equity fund — either domestic or global —in the proportions that are right for you will do the trick. This will provide a widely diversified, low-cost portfolio that will outperform most active funds with less risk and lower taxes, provide more confidence and comfort and take less time.
9. After experience with the basic index funds, you may decide you strongly expect superior long-term prospects for a particular kind of investment or nation (emerging-market stocks or Japanese stocks or small-cap stocks, for example). In that case, you may want to “overweight.” Just be sure to stay with this for at least a decade, because indexing works best when sustained long term.
A Word About Asset Allocation
It can be difficult to allocate investments across multiple asset classes when you have just $1,000 to invest, but the suggestions above should get you started.
As your portfolio grows, you'll likely want exposure to foreign stocks, and perhaps emerging markets, REITs and small company stocks.
And over time you'll likely want to include some bond funds in your portfolio. Initially, however, an S&P 500 index fund is a perfect place to start investing.
In Summary, the basic indexing decisions are simple and, once made, stay decided until the time comes for a change in your long- term investment strategy because your goals have changed in an important way.
***As a disclaimer – I am not an investment advisor and am not providing investment advice. I am merely giving you the benefit of my personal experience in investing.***
Until next week
November 22, 2017
Join me every Wednesday on my podcast “Unlocking the Secret to Living Rich”.
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Who is Cindy B. Brown? Cindy is a CPA, MBA, CFO, board member of public and private companies, business consultant, entrepreneur coach and a foremost expert in the field of financial
mastery.Cindy’s purpose is to motivate, educate and inspire people to live their richest life. Host “Unlocking the Secret to Living Rich”.