Investing isn’t my second nature and I am scrambling up a steep learning curve to master the fundamentals. I sometimes feel like an inexperienced mountain climber who just realized he is afraid of heights while hanging off a cliff. The good news? While a mountaineer has little tolerance for mistakes, I can afford them. More or less. And I like to believe I am a fast learner and won’t make the same mistake more than once.
Preferably, I don’t make mistakes though. And one of those mistakes could be having a non-diversified portfolio (most of my assets are shares in one single company). Without exception, people have strongly advised against it. And the fact that this company is my employer doesn’t make the situation better. On the contrary, it has been called ‘a single point of failure’. If the company goes bankrupt I not only lose my job, but also my shares.
I completely understand that viewpoint. I still sleep well though. Mainly because I sleep in a mortgage-free home. But also because the bankruptcy risk – let’s say bankruptcy within the next 2 years – is very small. Not impossible (it never is), but very small.
Having said that, I do feel diversification would be a smart move and in this post I will look at index funds as a diversification option.
What does Google say?
The common thread seems to be: They’re easy, spread risk, are low cost and in the long run they perform better than actively managed funds.
This is what Warren Buffet says about it:
Consistently buy an S&P 500 low-cost index fund. I think it’s the thing that makes the most sense practically all of the time.
You don’t know who Warren Buffet is? He’s an American business guy and a very successful investor. If he says jump, we jump.
So what are you waiting for Marc? Why don’t you jump?
What is an index fund?
First of all, what is an index? Or rather stock index?
A stock index is a tool that helps investors to see how the market is performing over time, by tracking a group of stocks. It’s value is computed based on the underlying stock prices. Some of the most known stock indexes are NASDAQ, S&P 500, and Dow Jones Industrial Average.
There are many indexes. Some indexes track the performance of a specific country’s market, whereas others represent the entire world’s market. There are also indexes that track only certain types of stocks, like growth stocks, value stocks or small-cap stocks. Or specific sectors, like finance.
Now, an index fund is a type of mutual fund (a pool of money from individuals that money managers invest in various securities, like stocks and bonds) with a portfolio that has been constructed to match (or replicate) a particular stock index. For example S&P 500 or Dow Jones Industrial. They’re passive in nature as opposed to actively managed funds (such as mutual funds).
If you invest in an index fund that tracks the Dow Jones for example, then your share will replicate the performance of the Dow Jones (because the index fund tries to own the very same stocks in the same proportions as the Dow Jones).
Why invest in index funds?
If you invest in index funds, you would never perform better (or worse) than the index that is being tracked by your index fund. Wouldn’t you want to beat the market?
Well yeah that would be nice, but here’s the thing:
- Statistics show that index funds outperform mutual funds in the long run (which are actively managed, whereas index funds are not)
- A beginner like me can invest in index funds and get good results (this would be highly doubtful if I handpick my own stocks).
- Index funds are more cost effective than actively managed funds
- Instant diversification
As far as 1) is concerned, the key is that while you never dramatically outperform the markets, you won’t under-perform either. This averaging out brings index funds out on top in the long run.
Regarding 2), let’s face it. Only if I am very lucky I outperform the market. To think that I can outperform it based on ‘know how’ would be a big mistake. It doesn’t mean I can’t handpick stocks. I can allocate some funds to a riskier corner of my portfolio and have some fun with it, but I should definitely not do that with all my money.
3) should not be underestimated. Actively managed funds are more costly (management fees, expense ratio). In the long run this can make a huge difference.
And finally 4). Index funds are per definition diversified. This saves me the effort and cost of having to diversify myself by handpicking stocks.
There is something called expense ratio. Actively managed funds have a relative high ratio. 1% or even more is not uncommon. This means they will deduct 1% of your fund balance each year.
If you invest $10,000 in a fund with a 1% expense ratio and the fund gains 10% each year, you’ll end up paying $11,175 in 20 years.
Don’t believe me? Have a look at the chart below.
The total expenses (grey line) is the total amount that is withdrawn from your balance.
‘That’s less than 6000’, you might think. But remember that your balance is reduced each year, so it’s a double hit (you can’t get a 10% return on money you no longer have).
By comparison, this is what the chart looks like with an expense ratio of just 0.05%
Now, compare the two charts and see where the balance (orange bars) end. Suffice to say that expense ratio has a huge impact in the long run.
Even if an actively managed fund performs better than your index fund, chances are you’ll still outperform it due to the (much) lower expense ratio.
About ETF’s (Exchange Traded Funds)
ETF’s are like index funds, but can be traded like stocks (the name says it all).
This means you can buy them using your regular brokerage account from the comfort of your living room. At any time during the day.
What ETF’s are there and how do I invest in them?
Investing in ETF’s is as easy as investing in stocks. Just use your brokerage account and look for ETF’s. There are many however, so the more difficult question is which ones you should invest in.
There are different types: US market, foreign market, foreign currency’s, sectors and industries, commodities, derivatives, bonds, etc. I lack the insight to say anything useful about them in this post, but stay tuned. I will definitely write more about it in the near future.
But let’s pick one: Vanguard’s Total Stock Market ETF (VTI).
It’s an ETF that tracks a blend of Large, Mid and Small cap companies in the US. Very low expense ratio (0.04%) and it has an average annual return of 14.24% (last 5 years).
The following is a screen shot from my brokerage account:
It’s performance is pretty impressive. And remember, statistics show that it is hard to do better.
Back to me and my portfolio
So what are you waiting for Marc? Everything you say points into one direction only and that is buy. Buy now! It surely looks tempting.
There are a few things that pop up in my mind:
- Never buy for the sake of it. Never invest in something just because others say you should. In the end it must be a decision based on your own careful assessment (and that could be that ETF’s save you all the hassle, so you go for it).
- Investing in ETF’s doesn’t mean you can’t lose money. You obviously can, but you’ll be following the general development of the market that your index is tracking. And as we saw, the performance is good (definitely in the long run).
- ETF’s could be part of what I would call the ‘defensive corner of your portfolio’. How defensive or aggressive/risky your overall portfolio is depends on the allocation of all your funds of course.
My portfolio looks as follows:
As you can see 83% is real estate (my mortgage-free home). I consider this to be the safe/defensive corner of my portfolio. It’s more than a corner really.
Now, 16% are shares in the company I work for. While this is the ‘single point of failure’ part of my portfolio, it is relatively small. It puts things a bit in perspective.
It doesn’t mean I shouldn’t do something about it, but selling off here and now in order to move funds to ETF’s instead is not my initial thought.
Let’s compare Vanguards ETF (lightblue line) with my company’s performance (last 5 years).
I like to see my company shares as the high risk growth corner of my portfolio. So far it’s paying off.
But ETF’s are great. I will most definitely allocate funds to them, especially when I get closer to financial independence and will adopt a more defensive strategy.
How about you?
Have you invested in ETF’s? Which ones? How much of your portfolio is allocated to them?