Some of the safest-looking places for putting your money are more hazardous than they appear. Here's why that's true.
Which investment involves lower risk: Putting your money in one company? Or buying shares in an S&P 500 index fund?
Nearly all financial advisers and many clients know that the index fund is much more diversified and therefore has less risk. Yet it is easy for clients to forget this basic fact when the chance to invest in a particular company presents itself.
When clients ask me to evaluate opportunities to invest in a private company, the stories are often compelling at first. Clients have brought me opportunities ranging from a marketing company looking to lower its costs by buying in bulk to a niche social media company looking to grow its user base. Almost all of the investments come from a trusted source, such as a long-time friend. But once I dig deeper into a company, I usually find major red flags.
Most of the time, I convince clients to pass on individual company investments. Occasionally, we agree that a small investment is acceptable. And sometimes a client will choose, despite the risks, to invest more in a small company than I would recommend.
Why does this happen?
Why Clients are Tempted to Invest in Private Companies
I see a few reasons why concentrated investments in private companies may tempt clients — even those who fully understand the importance of diversification. A personal connection is powerful. If you believe someone to be a good person overall, you’re more likely to trust him and assume that he’ll make a successful business partner too. While viscerally reassuring, this familiarity may make investors overconfident in a company’s prospects. Even with good intentions, skill, and an attractive market, unforeseen problems can still ruin individual company investments.
Clients can also get a skewed perception of the success rate of individual-company investing for the same reason that it seems like your Facebook friends are always on vacation or eating great meals: It’s fun to talk about your winners. You can see this tendency on display in the TV show Shark Tank. After a wealthy “shark” invests in a company, the producers provide updates that highlight the successes but don’t mention the failures.
Financial advisers can sometimes share the blame for clients’ interest in individual company investing. We know that it’s important to focus on the big things in clients’ lives, such as how much they save and their overall asset allocation. As a result, we spend so much time talking about markets in the abstract that we sometimes forget to emphasize that markets and indices are composites of many individual companies. We talk about the forest, but clients don’t see any of the trees.
Refocusing on a Diversified Portfolio
If people are inclined to believe that the market as a whole is overvalued, it can be hard to convince them to invest broadly without telling a good story, with identifiable characters. Even if you allocate to broad index funds, that doesn’t mean there’s no story to discuss. Individual companies like Apple, Exxon or Procter & Gamble are large components of the S&P 500 that can easily make the investing story relatable for clients. While one company’s impact on a portfolio is likely negligible, discussing it in more detail can improve clients’ understanding of their investments and remove the false impression that private companies are the only ones that prosper.
If a client is insistent on a more concentrated portfolio, adding a small stake in a private equity fund might be an attractive alternative to directly investing in a private company. Although these funds are riskier than mutual funds, they still incorporate professional management and some diversification.
If a client wants to pursue individual company investments because they’ve gotten wrapped up in a compelling story, remind them that the most interesting investing stories can often result in expensive lessons. Discuss the specific investment’s risks, mention the biases that may be influencing their behavior, and — if all else fails — consider telling a better story.
Benjamin Sullivan is a manager at Palisades Hudson Financial Group, where he helps the firm’s high-net-worth clients with their personal financial planning, investment and tax planning needs. He is a certified financial planner certificant, an IRS enrolled agent, and a member of the New York chapter of the Financial Planning Association.
These relatively painless investing tweaks can put you on the path to a secure retirement, even if you just do one or two of them.
Think you’ve got to come up with a big score or magnificent coup to boost the size of your nest egg and dramatically improve your retirement prospects? You don’t. A few simple tweaks can often make the difference between scraping by and living large after you retire.
In fact, you can put yourself on the path to a much more enjoyable and secure retirement with just three relatively easy moves: saving a little more, paring investment expenses and delaying retirement a bit. Here’s an example.
Let’s say you’re 30 years old, earn $45,000 a year, get annual raises of 2% and contribute 10% of your pay to a 401(k) or similar plan. And let’s further assume that your retirement savings earn a 7% annual return before expenses, for a net return of 5.5% after investment fees of 1.5% a year. Based on that scenario, by age 65 you would have a nest egg valued at just under $600,000.
Not bad, and certainly more than what most people age 65 have accumulated today. But you can put yourself in a much better position at retirement time if you make the three adjustments I mentioned.
First, let’s see how much saving more can help. If you increase your savings rate from 10% a year to 12%, that move alone would boost the age-65 value of your nest egg from just under $600,000 to nearly $715,000. That’s a gain of roughly $115,000, or almost 20%, right there.
Next up: investment fees. With the multitude of index funds, ETFs and other low-cost choices that are around these days, paring annual investment expenses is eminently doable. So, for the sake of this example, let’s assume you cut annual fees by just 0.5% a year from 1.5% to 1%, for an after-expense return of 6% instead of 5.5%. That reduction in expenses alone would add another 10% or so to the age-65 401(k) balance, pushing it from a little under $715,000 to nearly $790,000.
Now for the third move: delaying retirement a few years. This single adjustment has a two-barreled effect on your nest egg. Postponing gives you a chance to throw more savings into your retirement accounts and it gives the money in those accounts more time to grow before you start drawing on it. Waiting three more years to exit the workforce in the scenario above would bump the age-65 value of your nest egg from just under $790,000 to just over $975,000, just short of seven-figure territory.
By the way, postponing your job-exit date can also improve your retirement outlook in another way: Each year between the ages of 62 and 70 that you delay claiming benefits, the size of your Social Security check increases roughly 7% to 8%, and that’s before annual adjustments for inflation. To see how different claiming ages might affect your Social Security benefit (and your spouse’s, if you’re married), check out the calculators in RealDealRetirement’s Retirement Toolbox.
In short, making these three moves combined would have boosted the value of your nest egg in this scenario from a little less than $600,000 to almost $1 million, an increase of some 60%. That’s pretty impressive.
Of course, you may not be able to replicate these results exactly. If you’re getting a late start in your savings regimen, increasing your savings rate may not translate to as sizeable an increase in your eventual balance. Similarly, if you do most of your saving through a 401(k) plan that doesn’t include low-cost index funds and such–although most plans do these days—you may not be able to cut investment expenses as much as you’d like. Even if you’re able to pare expenses, there’s no guarantee that each percentage point reduction will mean a percentage-point increase in return, although there’s plenty of evidence that funds with lower costs do generally perform better.
And while many people may want to work a few extra years to fatten retirement accounts, health problems or company downsizing efforts may not allow you the choice of staying on the job a few extra years.
Still, the point is that these three moves, individually or combined, can likely improve your retirement outlook at least to some extent. And they’re much more effective at enhancing your retirement prospects than the move that many mistakenly gravitate to: investing more aggressively, which is a tactic that can backfire and leave you worse off.
So re-assess your retirement planning to see which of these moves makes the most sense for you. If doing just one gives you the boost you need to assure a secure retirement, fine. But if just one won’t do it, try to do two, or all three. Come retirement time, you’ll be glad you made these tweaks.
MORE FROM REAL DEAL RETIREMENT:
These basic yet effective moves can help you get the investment gains you need without taking on outsize risk.
With financial pundits incessantly speculating about where stock prices are headed or blathering about a seemingly endless stream of “revolutionary” new investment products, you could easily get the impression you need to constantly revamp your retirement portfolio. But guess what? You don’t.
In fact, you’re more likely to hurt your retirement prospects by focusing on the ups and downs of the market and overdiversifying into fad investments. A better strategy: stick to a few simple but effective principles that can help you get the investment gains you need without incurring outsize risks.
Here are four tips that can help you add juice to your retirement portfolio’s performance and boost your odds of achieving retirement security.
1. Focus on building a portfolio, not picking funds. Many people think smart investing starts with selecting specific funds. But that approach is backwards. Before you start homing in on individual funds or any other type of investment, you need an overall plan.
Specifically, you want to put together a portfolio that not only includes stock and bond funds, but a broad range of both (growth and value stocks, large shares and small; government and corporate bonds). The aim is to create a diverse group of investments that don’t all move in synch with one another. This way, when one part of your portfolio is getting routed, another part can be racking up gains—or at least not get battered as badly.
The mix of stocks and bonds you own should be based on factors such as your age, your investing goals and your tolerance for risk. Generally, the younger you are, the more of your money you’ll want in stocks.
For guidance on creating such a portfolio, you can check out the investing tools in the Real Deal Retirement Toolbox. If you find the idea of building your own portfolio daunting, consider a target-date retirement fund, an all-in-one fund that includes a diversified mix of stocks and bonds and that becomes more conservative as you age. Though far from perfect, target funds are a good choice for people who can’t or don’t want to build a portfolio on their own.
2. Seek to track, not beat, the market. Aspiring for “average” results by investing in index funds or ETFs that track the performance of market benchmarks strikes some as an admission of failure. It shouldn’t. If you earn the average market return—or something close to it—you can grow your retirement stash substantially over time.
If ten years ago you had invested $10,000 in a total stock market index fund—a fund that tracks the entire U.S. stock market—you would have earned an annualized return of almost 9% and be sitting on a stash worth more than $23,000 today.
Sure, some funds did better. But most didn’t, and it’s hard if not impossible to identify in advance the ones likely to outperform. Indeed, S&P Dow Jones’s latest “Persistence Scorecard” shows that very few funds can consistently outperform their peers. Besides, what sometimes looks like superior performance is just a fund taking on a lot more risk, which makes it more vulnerable to market setbacks.
If you stick to broadly diversified stock and bond index funds, you can avoid the whole fund-picking racket, and fare much better than investors who are constantly seeking out hot funds.
3. Control your emotions. When the markets are surging, people tend to get overconfident about their investing abilities and underestimate the risk they’re taking. That’s one reason investors pour so much money into stocks after the market’s been on a run.
By contrast, in the wake of a market crash investors become overly cautious and often dump stocks and huddle in bonds and cash, even though stocks are usually more attractively priced after big downturns.
You’re much better off avoiding this emotional roller-coaster ride and maintaining your composure. Once you’ve created a portfolio of stocks and bonds that makes sense for you, you should largely avoid tinkering with it whatever the market is doing, except to rebalance back to your original asset mix periodically (say, once a year). By taking your emotions out of the game and adhering to the simple disciplined strategy of rebalancing back to your target stocks-bond mix, you’ll avoid the classic investor mistake of loading up on assets when they’re likely overpriced and selling after they’ve taken a beating and may be bargains.
4. Rein in costs. People tend to gravitate toward investments that have recently posted the highest returns. But returns are highly volatile. And a fund or stock that’s topping the performance charts one year may be an also-ran the next.
Expenses, on the other hand, are much more predictable. A fund that has much higher management fees than its peers will probably stay that way—its costs aren’t likely to go down. And since each dollar you pay in expenses lowers your net return, bloated fees act as a drag on a fund’s performance. Over the long-term that can seriously stunt the size of your retirement nest egg.
That’s why low-cost funds tend to outperform their high-fee counterparts over long periods of time. Which is another argument to stick mostly to index funds, which typically have some of the lowest expenses around. You can screen for low-cost funds by going to the Basic Screener in the Tools section of Morningstar.com. (The tool is free, but registration is required.)
There are no guarantees in investing. But if you follow the four tips above, you should be able to substantially boost the value of your nest egg without subjecting it to undue risk.
More from RealDealRetirement.com:
The big companies favored by mutual fund managers have substantially underperformed the S&P 500 index this year.
Even fund managers’ best ideas are not working out this year.
In one sign of the poor performance of stock picking by fund managers as the U.S. stock market continues to rally, the largest overweight positions by large-cap fund managers substantially underperformed the broad Standard & Poor’s index over the first half of the year, according to a Goldman Sachs research report.
Those stocks which were the most shunned, meanwhile, posted above-average returns.
Visa, the most overweight position among the 485 large-cap funds included in the Goldman Sachs study, is down 0.4% for the year, while Exxon Mobil, the most underweight, is up 1.1% over the same period.
Overall, well-loved stocks gained 6% on average for the year through June, while the S&P 500 gained 8% over the same time. The most underweight stocks, by comparison, rallied by an average of 10 percent, according to the report.
The underperformance of active fund managers comes at a time when stock pickers were expected to prosper. The aging bull market, which began in 2009, and falling stock market correlations after last year’s big rally were supposed to make 2014 a time when fund managers would be rewarded for picking companies based on their fundamentals.
Yet poor stock selection is one reason why just one in five actively managed large-cap stock funds are beating the S&P 500 for the year so far. Typically, about 40% of managers best the S&P 500 over the same period, said Todd Rosenbluth, director of fund research at S&P CapitalIQ.
“What funds need to do to outperform is find unloved stocks and get in front of it. If they hold the same stocks that other managers are overweighting, then it’s more likely that they are just going to tread water,” Rosenbluth said.
Underweight stocks’ performance this year seems to bear that out. Shares of Goodyear Tire & Rubber, the company with the largest underweighting among consumer discretionary stocks, is up nearly 16% for the year to date, while shares of Essex Property Trust, the most underweight financial company, have rallied 32%.
Other companies with significant underweighting include Apple, PepsiCo, and Ventas, according to the Goldman report.
The lack of a significant market pullback could be another reason for the underperformance, Rosenbluth added. The S&P 500 has not had a pullback of 10%, known as a correction, in three years. That has made it hard for managers who sold during last year’s 30% rally in the S&P 500 to find places to invest their cash, he said.
“Some managers were prudent and sold during the rally, and now they are left wondering what to do,” he said.
Managers of target-date retirement funds seek to boost returns with tactical moves. Will their bets blow up?
Mutual fund companies are trying to juice returns of target-date funds by giving their managers more leeway to make tactical bets on stock and bond markets, even though this could increase the volatility and risk of the widely held retirement funds.
It’s an important shift for the $651 billion sector known for its set-it-and-forget-it approach to investing. Target-date funds typically adjust their mix of holdings to become more conservative over time, according to fixed schedules known as “glide paths.”
The funds take their names from the year in which participating investors plan to retire, and they are often used as a default investment choice by employees who are automatically enrolled in their company 401(k) plans. Their assets have grown exponentially.
The funds’ goal is to reduce the risk investors take when they keep too much of their money in more volatile investments as they approach retirement, or when they follow their worst buy-high, sell-low instincts and trade too often in retirement accounts.
So a move by firms like BlackRock Inc., Fidelity Investments and others to let fund managers add their own judgment to pre-set glide paths is significant. The risk is that their bets could blow up and work against the long-term strategy—hurting workers who think their retirement accounts are locked into safe and automatic plans.
Fund sponsors say they aren’t putting core strategies in danger—many only allow a shift in the asset allocation of 5% in one direction or another—and say they actually can reduce risk by freeing managers to make obvious calls.
“Having a little leeway to adjust gives you more tools,” said Daniel Oldroyd, portfolio manager for JPMorgan Chase & Co’s SmartRetirement funds, which have had tactical management since they were introduced in 2006.
GROWING TACTICAL APPROACH
BlackRock last month introduced new target-date options, called Lifepath Dynamic, that allow managers to tinker with the glide path-led portfolios every six months based on market conditions.
Last summer, market leader Fidelity gave managers of its Pyramis Lifecycle strategies—used in the largest 401(k) plans—a similar ability to tweak the mix of assets they hold.
Now it is mulling making the same move in its more broadly held Fidelity target-fund series, said Bruce Herring, chief investment officer of Fidelity’s Global Asset Allocation division.
Legg Mason Inc says it will start selling target-date portfolios for 401(k) accounts within a few months whose allocations can be shifted by roughly a percentage point in a typical month.
EARLY BETS PAYING OFF
So far, some of the early tactical target-date plays have paid off. Those funds that gave their managers latitude on average beat 61% of their peers over five years, according to a recent study by Morningstar analyst Janet Yang. Over the same five years, funds that held their managers to strict glide paths underperformed.
But the newness of the funds means they have not been tested fully by a market downturn.
“So far it’s worked, but we don’t have a full market cycle,” Yang cautioned.
The idea of putting human judgment into target-date funds raises issues similar to the long-running debate over whether active fund managers can consistently outperform passive index products, said Brooks Herman, head of research at BrightScope, based in San Diego, which tracks retirement assets.
“It’s great if you get it right, it stings when you don’t. And, it’s really hard to get it right year after year after year,” he said.
Q: Does investing in a “total stock market index fund” give you diversified exposure to large-, medium-, and small-sized companies? Or do I need to invest in separate mutual funds for my large- and small-company stocks? — Toby, Davis Junction, IL
A: No, you don’t need separate funds. The Vanguard Total Stock Market ETF VANGUARD INDEX FDS TOTAL STOCK MARKET ETF VTI 2.3652% is designed to give you exposure to a broad cross-section of different types of domestic equities in a single exchange-traded fund.
Its portfolio breaks down like this: around 72% is invested in large companies, a little less than 20% is in medium-sized businesses, about 6% is in small-company shares, and 3% is in so-called micro-cap stocks.
Now, you can achieve similar diversification by allocating your dollars into a collection of more narrowly constructed funds that focus on industry-leading large companies or quick-growing but volatile small companies.
For instance, you could pick up Money 50 funds Schwab S&P 500 Index SCHWAB CAPITAL TST S&P 500IDX SEL SWPPX 2.4188% , with iShares Core S&P Mid-Cap ISHARES TRUST REG. SHS S&P MIDCAP 400 IDX ON IJH 1.6938% and iShares Core S&P Small Cap ISHARES TRUST CORE S&P SMALL-CAP ETF IJR 1.4761% . (Although, if you’re not careful, you might end up with more exposure to smaller companies than you want. About 30% of IJR’s portfolio is in micro-cap stocks.)
All things being equal, says BKD Wealth Advisors’ portfolio manager Nick Withrow, you’re better off going with the one fund than three or four.
For one thing, each fund comes with its own expenses. If VTI dovetails with your risk tolerance, then you’ve taken care of your domestic stock portfolio at a measly cost of 0.05% of assets annually. That’s marginally cheaper, by about 0.06 percentage points, than buying a host of exchange-traded funds that collectively approximate VTI’s portfolio, says Withrow.
But there’s another reason — you.
Basically, you don’t want to get into the business of buying and selling ETFs to try and time the market. And you’re much less likely to get into that expensive habit if you buy-and-hold one fund, rather than picking three or four.
“The more choices an investor has, the more apt he or she is to feel that they have to do something,” says Withrow. “The idea of simplicity, especially with a buy-and-hold attitude, goes a long way.”
Of course, one total market exchange-traded fund doesn’t mean your portfolio is complete. Don’t forget about foreign equities or, you know, bonds. But when it comes to U.S. stocks, one cheap total market ETF (like VTI) is particularly useful.
You don't need pricey money managers to help you buy low and sell high.
With the 4th of July on the way, the editors here at Money.com asked me to think about what it takes to become an independent investor.
I’ll take “independent” to mean something that most people with a 401(k) or an individual retirement account can realistically do. I’m not talking about sitting at your desk all day trading your own portfolio of stocks. In fact, the way I think about independence, you’ll want to automate about 99% of the investment decisions in your portfolio — specifically, which individual stocks and bonds to hold. The independence that matters has nothing to do with security selection. It’s about cutting out costly middlemen, from advisers who help you select investments, to the managers who pick the securities inside the mutual funds you may hold.
The rewards to doing this are significant. A high-cost mutual fund may shave 1% or more off of your investments each year, which can easily add up to six figures in fees and foregone gains over a lifetime as an investor. Eliminating layers of management also means you are less exposed to the quirky risks someone else might take with your money.
You don’t need a lot of time or expertise to pick these middleman-free investments. You can build a portfolio that holds a diversified slice of stocks and bonds with just three index mutual funds, portfolios that mimic the composition of the overall market at very low cost. If stocks rise 8% in a year, you’ll earn 8% or very close to it. You very likely have index options in your 401(k) plan—if not, say something to your HR manager!—and index funds are easy to buy in an IRA.
Below is what that portfolio might look like. You can adjust the split depending on you appetite for risk, but the one below is a good starting point for many long-term investors saving for retirement. (The less you can stand to lose, the more you’d add to the bond fund.)
In contrast to typical funds, this portfolio will cost you less than 0.1% of assets per year, and will get with three easy decisions exposure to literally thousands of stocks. You can choose index funds from our Money 50 list of recommended funds.
It’s easy to say that anyone can do this, of course. But I think a lot of people lean on investment middlemen because they aren’t sure they know enough about investing to do it themselves, and even if they want to learn, they aren’t sure which knowledge really matters. There’s so much you could dive into: stock sectors, “P/E” ratios, the January effect, EPS growth, upside earnings surprises, etc., and etc.
So here’s the one thing I think you have to understand to be a competent, on-you-own investor: Where the return on your investments really comes from. And the answer is that, for stocks, it comes from two sources. You own businesses, and you are taking a risk to do so.
Beginners are often introduced to the market with the old saying, “buy low and sell high.” This isn’t wrong (doing it the other way sure won’t feel good), but it’s not at all helpful. It makes investing sound a like a game of wits against other investors — first you figure out when a stock is too low, and then sell it when somebody else is willing to buy it for more than its worth. That’s hard, and you have to learn a lot about companies, accounting and human psychology to even attempt it. The whole edifice of the middleman money management business is built on the fact that most people believe they can’t do this themselves, or don’t want to.
But to be a buy-and-hold index investor, you can throw out “buy low/sell high” and the game-playing thinking that tends to go with it. This isn’t about finding a greater fool to buy your stock further down the road. Owning stocks gives you a claim on the earnings of companies. As an owner, you make money over time either because you are being paid a dividend out of profits, or because profits are being reinvested in the business to make it more valuable. Index funds give you a share in the future profits of the America’s, or the world’s, public companies. It’s almost as simple as that. Almost.
The other, crucial part of the equation is that the earnings of companies are uncertain and so are the cash flows shareholders will get. Stock investors get no promises that a company will ever earn enough to produce a dividend. Investors typically bake that risk into the market price of stocks, so that they can hope to be compensated with a higher return than they’d get on bonds. Historically, stocks have earned about 4.5 percentage points per year above bonds. Stock investors have on average been paid for risk — but that doesn’t mean you’ll always get paid for risk. Case in point: The nearly 50% loss investors took on blue chip stocks in the wake of the financial crisis.
If you get that, you have the baseline knowledge you need to build a diversified portfolio and stick with it. The potential for loss is built into stock investing and you only make money if you are willing to live that. The rest is (usually expensive) fiddling around the edges.
A new study suggests insider trading is even more rampant than anyone thought. But it's not so obvious why individuals should be concerned.
Between Michael Lewis’s takedown of high-frequency traders in Flash Boys and a new study finding that one in four M&A deals are preceded by insider trading, Wall Street’s public image is looking more “sell” than “buy” these days.
But how much does insider trading actually harm the average Joe? Even if Gordon Gekkos are running amok, do cheaters pose a real threat to those who play by the rules? The answer might surprise you.
1. Insider trading won’t hurt you if you don’t trade. Just like front-running high-frequency traders, those who trade on secret information are unlikely to hurt the portfolios of buy-and-hold investors, says Rick Ferri, founder of Portfolio Solutions.
In theory, an individual who frequently trades could be unlucky and end up buying or selling just as market-riggers are doing the opposite. But holding a diversified portfolio of stocks over long periods of time dilutes that damage; if you hold an index fund for a decade, you’d likely lose no more than pennies from trading inequities, says Ferri. “Getting upset about insider trading is like getting upset about the NFL draft,” says Ferri. “It makes for juicy headlines, but unless you’re a professional, it’s not really going to affect you.”
2. Insider trading could even help you. The presence of cheaters in the market could, coincidentally, benefit uninformed investors who just happen to land on the right side of a trade, says Santa Clara University finance professor Meir Statman, who has studied investor perceptions of insider trading. Let’s say you need to sell a stock in a company to free up cash, says Statman: If that happens to coincide with an insider trading-driven run-up before the company announces a merger or acquisition, you could actually win out.
3. Nevertheless, these cheaters are destroying the American Dream. Pundits have used the points above to argue that insider trading should be legalized. But the so-called “victimless crime” claims at least one victim, says Statman: confidence in the market. “A belief in fair play is part of good American culture,” says Statman. “The stock market is supposed to be an emblem of the American Dream: the belief that if you work hard and do your research, you’ll be rewarded. It’s not supposed to feel like the lottery.”
In his research, Statman has found that people living in economies riddled with more corruption, like India and Italy, are twice as likely as Americans to deem insider trading acceptable.
There are a few key takeaways: If we want to keep our markets fair, it’s important that cheaters are caught and punished. But news headlines shouldn’t prevent you from investing, as long as you do it wisely — with diversified index funds and minimal trading. “Trading is like going into the jungle,” says Statman.
“There will always be beasts who are larger than you and thus able to devour you,” he says. “So go in as rarely as possible.”
A financial pro gives a young investor some advice on the smartest ways to gain exposure to the market.
Q: I am in my early 20s and am looking to expand my investment portfolio. I currently have a small 401(k) and an S&P 500 index fund. Should I keep building up my index fund or start diversifying into something with a higher return potential? — Caroline, California
A: Participating in a 401(k) and investing in an S&P 500 index fund are a good start in your early 20s, notes Jim Ludwick, president of MainStreet Financial Planning.
Index funds — which simply buy and hold all the stocks in a market index such as the S&P 500 — aren’t as flashy as actively managed portfolios, where stock pickers can choose only those shares that they think are promising. However, index funds are a simple and inexpensive way to gain exposure to the market.
And there are years, depending on the market, where they can produce some sizeable gains. For instance, in 2013, the Vanguard 500 index fund, which tracks the S&P 500 index, returned more than 32%. That’s around three times the long-term average annual gain for stocks.
However, index funds are only as diverse as the market they track. So a good way to expand at this point would be to invest in other index funds that go beyond the S&P 500 index of U.S. blue chip stocks. An index fund that tracks the Russell 2000 index, for example, would give you exposure to shares of faster-growing small U.S. companies which your existing portfolio lacks.
You can add a Russell 2000 index fund to your mix to complement the S&P 500 fund, which gives you exposure just to large domestic companies.
Or for simplicity, you could trade in your S&P 500 fund for a so-called total market index fund, which in a single portfolio gives exposure to both large and small U.S. firms. “Expanding into a whole market index,” Ludwick notes, “is a very effective way to do it.”
Ludwick further highlighted the importance of investing in overseas markets for those seeking to expand and diversify. He noted that the Vanguard FTSE All-World ex.-U.S. ETF (ticker: VEU), which tracks stock markets outside the U.S., would be a good, low-cost complement to your U.S. holdings.
When investing in index funds, it’s important to comparison shop among vendors — Vanguard, Fidelity, Charles Schwab, iShares, SPDR all offer index products — for fees. Keep in mind that the expenses you pay are deducted from the market returns the fund generates, so the less a fund charges in fees, the more of its returns you get to keep.
Beyond index funds, you could branch out into actively managed portfolios. Studies have shown that over the long run, the majority of actively managed funds trail the basic indexes. Ludwick says active management is effective only in niche markets. That’s where the “insight really pays off,” he says.
However, as with all funds, the lower you can keep the fees, the better off you’re likely to be in the long run.