Diversification is the Key to Happy Investing

Diversification is the “D” in my PDQ Principles of investing. The S&P 500 Index Fund is a very low-cost way to gain broad exposure - DIVERSIFICATION - in the domestic equities market.

You’ve heard me say this before, but I’ll say it again. For small investors simplicity is the key to successful investing. Building a complicated investment portfolio can lead to confusion, greater expense, a lot more fretting (worry), and not infrequently, it can cause us to second-guess the choices we make.

Dwell on this contention for a moment: The most important aspect of wise investing, in my opinion, is BEHAVIORIAL, NOT FINANCIAL. I’m talking about the ability to save and invest on a continuous basis while ignoring perfectly normal human compulsions – compulsions to “bail out” in a down market fearing a loss – temporary though it might be – or to change those consistent buying patterns fearful of missing out on the “next big opportunity”.

Remember this, folks. The decision trigger is hard to pull when a market is surging – up or down. So, to avoid these compulsive behavioral issues, I suggest implementing a consistent buying pattern of… hopefully… quality investments and stay put. Yeah, I know, staying put in a “big ole pullback” is very difficult, but a great deal of money is lost when folks flush like a spooky covey of quail early in a major downturn, and not necessarily because they are saddled with a poor investments.

Diversity = Index Fund

Speaking of positions, let’s talk about my old friends, the index funds. I know, I know, you’ve heard me talk about them, ad nauseam, but a brief retelling of some reasons for investing in index funds is on my mind today. Remember diversification, the “D” of the PDQ Principles of investing? The S&P 500 Index Fund is a very low-cost way to gain broad exposure to the domestic equities market. The S&P 500 Index consists of 500 of the largest U.S. companies listed on the New York Stock Exchange or NASDAQ, selected by the Standard & Poor's Index Committee based on market capitalization. It is a widely recognized barometer of the U.S. equity market. An S&P 500 Index fund seeks to provide investment results that correspond to the price and yield performance of the S&P 500 Index, its benchmark index. To achieve this objective, an indexing strategy invests nearly all its assets in stocks with approximately the same proportions as the weightings.

The S&P 500 Fund creates ownership in 500 of the largest U.S. companies spanning many industries that, collectively, account for more than 75% of the U.S. stock market’s value. An associated risk, of course, is exposure to an occasionally volatile stock market. Just remember that old saying, “stocks fluctuate”. Since the S&P 500 Index Fund (or if you prefer, a Total Stock Market Fund) is so broadly diversified, I consider it “the” core equity holding for my own piddling little pile of quarters.

Minimize Pesky Fees

Recent history has proven that low-cost index funds result in superior long-term yields for small investors versus a scattergun approach – superior even to yields attained by other perhaps more experienced investors. And I’m including the big boys: pension funds, institutions, and many affluent folks who seek the help of pricey financial Wazoos. You just can’t beat the price. Index fund fees are as inexpensive as it gets. For example, combined, a 90% mix of stocks and 10% short-term bonds purchased through Vanguard would result in annual operating fees in the neighborhood of 0.055% of the account balance, amounting to $55 per year per $100,000 of investment, if you invest in the least expensive variant of the funds.

By contrast, the average “Wazoo-managed” fund is 20 times more expensive than the previously mentioned two-fund solution touted by none other than that penniless old vagrant from Omaha, Warren Buffet (i.e., he deals in billions, not pennies). I personally invested 10% of my stray dimes in short-term government bonds and 90% in a very low-cost Standard & Poor’s 500 Index fund years ago to establish my core investment portfolio.

Passive is Lucrative

The S&P 500 Index Fund seeks to replicate the performance of the benchmark index by investing in the S&P 500 companies with similar weights. This fund employs a passive investment strategy and invests all or a substantial amount of its total net assets in common stocks included in the benchmark index.

Still not buying this business about index funds? Studies show that two-thirds or more of active managers underperform the S&P 500 Index. Studies also reveal that during the most recent 15-year period, more than 90% of active managers underperformed their benchmark indexes. The picture that emerged from one such 15-year study was attention-grabbing, to say the least: 92.2% of large-cap funds lagged a simple S&P 500 index fund. The percentages of mid-cap and small-cap funds lagging their benchmarks were even higher: 95.4% and 93.2%, respectively.

In short, the odds that a managed fund will beat the yield of an index fund are only about 1 in 20. And in a given year, you never know who that 1 of 20 managers is going to be.

Keep in mind, too, that passive index funds are more efficient than managed funds. Most managed funds trade stocks frequently; thus, they tend to not necessarily earn more while realizing more taxable gains each year. Passive managers simply add or subtract companies in their funds less often, creating fewer capital gains tax liabilities.

In summary, passive index funds are not burdened with researchers and stock pickers, which results in low annual expense ratios (fees). And since they follow a market measuring index they are very transparent. And equally important, buying index funds is a simple approach for new investors, and boy do I love simplicity. For a slam dunk primer on the pros… and cons… of index fund investing, I recommend reading this carefully researched article by Motley Fool contributor Jason Hall. It may be more than you ever wanted to know about index funds but take a peek anyway. It’s very enlightening.

Remember old Ben Franklin’s sage advice:

"An investment in knowledge pays the best interest."