Too busy to follow the stock market? A portfolio of index funds may be the solution for you.
Charles J. Callea, DDS, CFP
Were you on board for the stock market`s wild ride last year when the Standard and Poor`s index posted a 37.5 percent gain? Or, were you sitting on the sidelines, kicking yourself for not being more heavily invested in stocks, but also knowing that you simply don`t have the time it takes to pick winners?
As someone who has a busy private practice of his own, I know just how little time is left for scoping out good buys when you leave the office after a long day. But experience has also taught me that stashing savings into low-paying CDs isn`t the answer, and paying an expert to make investment decisions can eat into your returns in a big way. That`s why, for the practicing dentist who has more on his mind than the stock market, a portfolio of index funds may be an excellent investment choice.
Mirrors Of The Stock Market
An index fund is a type of mutual fund that buys and holds the same stocks included in a particular market index. A market index is simply a group of stocks selected for tracking because they are representative of a category of companies, such as industrial companies or small companies. Investors watch the performance of the stocks in an index as a way to gauge the movement of all stocks in that category. The most common market index is the Standard & Poor`s 500, which follows the performance of 500 large U.S. companies, but other indexes also exist.
An index fund buys stocks in a given index in an attempt to mirror returns posted by the index. The fund does not try to outperform the market by buying and selling stocks the fund manager thinks are hot. Instead, the manager buys and holds representative stocks in the index. The goal of the fund is to provide a "market" return less any management fees and transaction costs. Since there are no active decisions other than picking the index, the funds costs are held to a minimum. That`s why buying an index fund is considered passive, rather than active, investing.
Stocks Top The Competition
When I talk about index funds, I`m referring to funds that mirror a stock index, not a bond index or Treasury Bill index.
Why stocks and not bonds, Treasury Bills or other investments? Consider this: Since 1926, investors have doubled their wealth approximately every 10 years in stocks, compared with 45 years to double their wealth in bonds, and 140 years to double their purchasing power when investing in money-market instruments. Even though the stock market experiences downturns, historically it has always posted more gains than losses over time. If you`re planning to invest for retirement or other long-term objectives, stocks will consistently outperform other investments.
Once you`re convinced that stocks hold the best promise of future wealth, your next decision is how to invest in them. If you have the time (and interest) to become an expert on publicly-held companies, consider investing directly in the stocks of 10-30 companies you like, using dividend reinvestment to purchase more shares. If you go this route, follow four rules:
1. Create a well-diversified portfolio;
2. Maintain a long-term perspective;
3. Stay fully invested; and
4. Take advantage of dividend reinvestment programs and no-load stock purchases.
However, one difficulty with individual stock-market investing, besides the time required to study the market, is having enough capital to create sufficient diversification in your portfolio. The need for diversification, coupled with the desire for professional management, has led millions of investors to invest in mutual funds, instead.
Actively-managed mutual funds are far from risk-free. Their success hinges on the ability of the fund manager to predict when stocks are about to go up and buy them, and know when to sell the ones that are headed for a nosedive. Because the manager is under short-term pressure to "beat the market," stocks are generally bought and sold more frequently, which leads to higher transaction costs and the possibility of more taxable capital gains for investors. You also run the chance that the manager will invest in risky options, futures, derivatives, illiquid securities or junk bonds in an effort to post short-term gains.
Actively-managed mutual funds have grown rich prom-ising to deliver great wealth to their investors, and it hasn`t always happened. It`s a fact, that the stock market has outperformed two out of three actively-managed mutual funds every year since 1978!
Index funds avoid the disadvantages common to actively-managed funds. Here`s why:
- iInvestors know what the fund manager will buy because the manager is limited to companies that are included in the index. The manager does not choose the stocks, he or she just mirrors an index. You don`t have to worry that the manager might be tempted to buy junk.
- Short-term gains are not the objective; rather, the objective is to yield returns as close as possible to the index by buying and holding stocks that are representative of the index. This lowers your chances of a spectacular performance, but it also lowers the risk of a big loss.
- Index funds do offer the potential of excellent gains. As an example, the average aggressive (translation: risky) growth fund returned 33.4 percent for 1995, while the passively-managed Vanguard Index Trust-500 returned 37.5 percent with much less risk.
- If an index fund suddenly becomes wildly popular and money floods into it, there`s no cause for concern because the manager will simply invest more money in the index`s stocks. In contrast, when money suddenly pours into an actively-managed mutual fund, the manager must scramble to find more good buys, with no guarantee of success.
- Index funds do not rely on an investment style, such as value investing or growth investing, so these funds aren`t affected if the style drifts out of favor.
- iThe index fund provides discipline to invest in stocks you might not ordinarily buy on your own. Such stocks, which are part of the index but may be doing poorly at the moment, could become your big gainers in the future.
- The manager of the index fund needs to keep very little cash in the fund, unlike actively-managed mutual funds which might keep as much as 10-50 percent of its assets in cash and still call itself a "stock fund." Index funds don`t need that much cash on hand, because the manager hasn`t invested in potential big winners he or she might be unwilling to sell, which is the case with active funds. Instead, the manager simply sells whatever proportion of the indexed stocks is needed to pay off investors.
- Management costs are kept to a minimum.
The issue of management costs is more important than it might appear on the surface. In fact, the primary reason mutual funds have underperformed the market is not because the manager is a bad stock picker, but because the fees they charge eat into returns. Mutual fund fees of 2-3 percent may seem small, especially when compared to year-to-year fluctuations in the market, but they are extremely detrimental to long-term growth.
As an example, if you invested a lump sum of $1,000 at a compound return of 11 percent per year (the average return on stocks since World War II), your initial investment would grow to $23,000 in 30 years. A 1 percent fee per year (most mutual funds charge 1-1/2 to 2 percent) reduces the final accumulation by almost one-third. And a 3- percent fee, which is not unusual, results in a final accumulation of a little over $10,000-less than one-half the market return. In contrast, management fees for index funds are much lower-about .3 percent or less.
In addition to an active mutual fund`s fees, think what your costs are when you pay someone to help you pick a fund. If the adviser charges 2-3 percent of assets under management every year, the long-term effect on your portfolio can be devastating. Even a 1-percent fee can have a significant negative effect on your portfolio over the long term.
Choosing An Index Fund
If you`re ready to invest in an index fund, here are a few suggestions:
- Decide if you want your portfolio to be 100 percent invested in index funds. Or, would you prefer to create a core portfolio (30-50 percent) of a low-cost index funds that cover a broad market index, such as the S&P 500, and then invest the balance of your money in stocks or stock funds of your choosing? The right mix depends on the amount of active involvement and portfolio volatility you want to assume in hopes of posting a reasonable gain.
- Not all index funds are the same. Indeed, some of them are better managed than others. Look for index funds with the lowest possible management fees.
- Check on an index fund`s Morningstar rankings for five- and 10-year periods. For example, over the past 10 years, the Vanguard S&P 500 index fund has ranked 17 out of 106 funds that contain similar types of companies.
- Include international index funds in your portfolio mix. International equities should be a part of any long-term investment plan-not because you necessarily can expect greater returns than with U.S. stocks, but because they allow you to diversify your risk far more effectively than a portfolio that only has domestic stocks. It`s not unreasonable to invest one-third of your entire portfolio in international stocks.
- Approximately one-third of your domestic portfolio should reside in small-company stocks. However, be aware that small cap index funds have not performed as well as actively-managed, small-company mutual funds.
In short, index funds may be the best course of treatment for the active dental professional who would just as soon remain a "passive" investor. Good luck!
The author has a private dental practice in Palatine, IL, and is a certified financial planner licensee. He can be reached at 708-934-3367.