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Index Funds Are Only Part of Your Investment Plan

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There isn’t a single reason why you shouldn’t like index funds. They’re cheap, they offer market rates of return without fail, and they are simple to buy. They beat actively managed mutual funds a majority of the time and they are often advocated as the best investment the average Joe can put their money in. So why not put all your money into an S&P 500 Index fund like the Fidelity Spartan 500 Index or the Vanguard 500 Index, call it a day and enjoy more time with the family? Because that would be a huge mistake.

The reality is that you can’t just open an account a online discount broker, buy only index funds or index ETFs, and then call it a day. The advice of personal finance experts isn’t that you should invest only in a single index fund, it’s to invest in a basket of index funds that diversifies your risk and offers you a fair return for the risk you are taking. An index fund represents only a small part of your diversified portfolio, it shouldn’t represent the entire portfolio because it exposes you to risk without paying you adequately for it.

Risk #1. Domestic Risk

If you have everything in an S&P 500 fund, then your portfolio depends on the performance of the United States economy. As anyone who has seen their brokerage statement lately, the stock market has declined significantly since last October and the economy has been slowing down since at least six months to a year beforehand. If 100% of your investment portfolio is in domestic investments, you’re over exposed to one single country. While it’s the best country in the world, it’s still risky to put all your eggs in this basket. Some of the greatest investment gains the last few years, helped on by the decline in the value of the dollar, has come in the emerging markets funds. While I wouldn’t advise plowing all your money there (especially now that the dollar is recovering), experts recommend around 5-10% of your assets in emerging markets funds.

Risk #2. Equity Risk

An S&P 500 index fund is 100% stocks (duh), which is probably at least double digit percentage points higher than what you probably want your stock allocation to be. As I mentioned earlier, the stock market had a 20% haircut from its highs last fall and if you held just an equity index fund like the S&P 500, you took on the full brunt of that fall. Experts advocate the 120 minus age rule when it comes to stock allocation: your stock allocation should be [120 - your age] percent of your portfolio, with the rest being in bonds. While the equation is subject to tweaking based on your situation and risk tolerance, the idea behind it is that you shouldn’t be too exposed to equities because they’re riskier than bonds.

Solutions

Are you convinced yet that 100% into an index fund is a mistake? I couldn’t just leave you with an explanation of what not to do without giving you a solution! There are two solutions for those who like to “set it and forget it:”

Solution #1. Target Retirement or Lifecycle Funds

Target Retirement or Lifecycle funds (Vanguard calls them Target Retirement, Fidelity calls them Lifecycle) are funds that adjust their asset allocation as the years pass. The idea is that you buy a 2045 Fund if you intend to retirement in 2045 and the broker adjusts the asset allocation such that the risk gets lower and lower as that date nears. Target retirement and lifecycle funds are composed of other mutual funds, many of which are passively managed. These funds are truly for the “set it and forget it” types because the broker rebalances the fund for the investors based on their models (and each broker’s model is different, I once wrote about how these target retirement funds compared with the 120 stock rule).

Taking a look at Vanguard’s 2045 fund, you’ll see that the asset allocation is composed of six funds in varying allocations:

  • Vanguard Total Stk Market Idx Fd Inc – 70.22%
  • Vanguard European Stock Index – 10.10%
  • Vanguard Total Bond Market Index – 10.00%
  • Vanguard Pacific Stk Idx Fd Inc – 4.38%
  • Vanguard Emerg Markets Stk Idx Fd – 3.81%
  • Vanguard Total Stock Market ETF – 1.46%

Solution #2. Lazy Portfolios

Lazy Portfolios are cleverly named portfolios that are designed specifically for the lazy “set it and forget it” crowd, which includes yours truly. They are simply asset allocation recommendations that rely on a basket of low cost mutual funds, which include index funds, to build a portfolio that is easy to manage. The most well known of these portfolios is the Couch Potato Portfolio, created by Dallas Morning News columnist Scott Burns, and it’s a 50-50 split of the Vanguard 500 Index Fund and the Vanguard Total Bond Fund Index Fund. Other cleverly named titles includes the Margaritaville Portfolio, the Coffeehouse Portfolio, and others.

The lazy portfolios aren’t entirely “set it and forget it” because they don’t rebalance themselves every year. Think of the portfolios as a recommended asset allocation, you still have to go in every year and rebalance them back to their recommended percentages.

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6 Responses to “Index Funds Are Only Part of Your Investment Plan”

  1. “The reality is that you can’t just open an account a online discount broker, buy only index funds or index ETFs, and then call it a day.”

    I disagree, though it’s unclear if you really mean what you’re saying here. While I would agree that holding a single index fund is a bad idea, you argue above in the statement above that you can’t safely rely solely on index funds (plural). While owning just a single index fund is probably a bad idea, it’s actually quite possible to build a nicely diversified, low cost portfolio using index funds. In fact, the Target Retirement fund you referenced is 100% index funds (or index ETFs).

    So… You argue that you can’t do exactly what you later say you should be doing. You’re wrong at first and right at the end.

  2. jim says:

    I always interpreted an “index fund” as one that matches the exact holdings of a particular index, such as the S&P 500 or the NASDAQ 100, and yes I did mean one specific fund.

    I know that some consider index to simply mean passive, or a collection of other index funds (which is basically what a Lazy Portfolio is), but for this article I meant solely the ones that matched index compositions.

  3. NickFro says:

    I’m a huge fan of the “Set It and Forget It” model offered by the various lifecycle/target date funds. My OCD/ADHD make me want to check my account balances far too often, and having most of my various retirement accounts in target date 2040 funds eliminates some of that desire. I have a few individual holdings, and an index fund, in one of my accounts, but the rest is a mix of Target Date funds and an annually rebalanced portfolio of various mutual funds (thanks TIAA-CREF). Future contributions are going 100% into target date funds. The trick there, I think, is to pay really close attention to the make-up of the MANAGERS of the fund (since they are a relatively new concept) — I’d rather be in a target date fund run by an experienced management team, than one run by this year’s crop of newly minted MBA i-bankers.

  4. For a lot of people Index Funds could be the best option. Especially for those that have some basic knowledge about investing. Index Funds are very large portion of my portfolio and all of them are 100% stocks as I’m growth oriented for next couple of decades.
    The 2 solutions are not bad, but I would recommend the Couch potato strategy to be implemented with a mix of funds from Canada, US and International market (some of the list in Sol.1) as a start.
    According to a article I read several months ago it was claimed as more important to do Industry based diversification than based on geography.

  5. Hmm… the 120-Rule means I should have 99% of my investments in stocks (well, 98% next week). Of course, I’m not going to worry about it until I’ve got the money built up to actually start buying some funds!

  6. Ria says:

    Which of the 2 methods do you suggest? I’m trying to decide between putting 100% of my money set aside for my roth IRAs each year for either the 2045 fund alone, or splitting it between various funds by following one of the lazy portfolios.
    Thanks!


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