Rational Investing Rule #3: Diversified Index Funds Are Your Friend
This is the third part of our five-part series on investment rules. Check out the first and second parts.
While the stock market as a whole returns a long-term average of ten percent per year, individual stocks experience drastically different fortunes.
For example, in 2013, the S&P 500 index grew 29.60%.
However, stock in Netflix (NFLX) soared 297.06%. Best Buy (BBY) was up 237.64% and Delta Airlines up 130.33%.
Meanwhile, Newmont Mining (NEM) dropped 51.16% and Teradata (TDC) fell 27.18%.
To smooth the market’s fluctuations, rational investors spread their money around. Surprisingly, studies show that while diversification reduces risk, it doesn’t affect average performance at all. (For more info, check out this guide to diversification from the U.S. Securities and Exchange Commission.)
Buying individual stocks isn’t really investing — it’s gambling.
By owning more than one stock, you reduce your risk. If you have ten stocks and one of them tanks, the damage isn’t as bad because you still own nine others. True, you don’t reap all of the rewards if a stock skyrockets like Netflix did in 2013, but rational people know they won’t pick winners every time. If you bank on picking the next Apple stock, you will end up playing the lottery with your retirement.
If you choose stock correctly one year, logic would dictate that the next year you will choose incorrectly. Since we are rational, we will diversify.
Investors also reduce risk by owning more than one type of investment. As we’ve seen, over the long-term stocks are better investments than bonds or gold or real estate. But over the short-term, stocks only outperform bonds about two-thirds of the time. Because the prices of stocks and bonds move independently of each other, investors can reduce risk by owning a mix of both.
One popular guideline is to base how much you invest in bonds on your age. If you’re 35 years old, put 35% into bonds and 65% into stocks. If you’re 53, put 53% into bonds and 47% into stocks. This is a fine starting point for the average investor.
I personally like to lean towards risk, so I like to amp up the percentage of stocks I own compared to the percentage of bonds I own.
One of the best ways to spread risk when investing is through the use of mutual funds.
Mutual funds are collections of investments. They let people like you and me pool our money to buy small pieces of many companies all at once. Imagine, for instance, the hypothetical perfect Fund, which invests in fifty different stocks and ten different corporate bonds.
By buying one share of the Awesome Fund, You, Inc. would have a piece of sixty different investments. If one goes bust, the damage is minimized.
Passively managed funds – also called index funds – try to mimic the performance of a specific benchmark, like the Dow Jones Industrial Average or S&P 500 stock-market indexes.
Because these funds try to match (or index) a benchmark and not beat it, they don’t require much intervention from the fund manager and her staff, which means their costs are much lower.
This is a win win for you.
The average actively managed mutual fund has a total of about 2% in costs, whereas a typical passive index fund’s costs average only about 0.25%.
Some fees in Fidelity or Vanguard accounts have fees closer to 1%. This difference in fees is the difference in thousands of lost dollars to you.
To come out ahead on a passively managed fund, the average fund manager doesn’t just have to beat his benchmark index — he has to beat it by 1.75%!
We personally stick all of our money in index funds like the Vanguard International Growth Fund or the Vanguard U.S. Growth Fund.
Keep the fees low and leave your money invested until you reach your desired retirement age (hint: this should be over age 70 at the very least).
Once you reach the age you want to start withdrawing money, work with a CPA to minimize your taxable income.
Stay Rational
-B&T