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.

(Photo: DustinMatthews)

The key to a successful investment plan is to pick one that fits your personal style. If you’re always busy and simply can’t find the time to pay attention to your investments, you need to pick a style that matches your life. There’s no sense adjusting your life to your investments, it should be the other way around. It’s difficult to pigeonhole anyone into one particular bucket but find the various suggestions in each grouping to see how best to use them to match your life.

The Novice

Everyone starts as a novice, there’s absolutely no shame in being a beginner when it comes to the stock market. In fact, it’s probably better that you’re a beginner. It was the experts that got us into the whole sub-prime mortgage mess. Until they closed their doors, the halls of Bear Stearns was full of experts. That being said, if you’re a novice when it comes to the stock market, put your money into a high yield savings account and start playing with a “play portfolio” at one of the finance sites. While you’re learning, your savings will still earn a nice interest rate.

When I was learning, I used Yahoo! Finance and a tool over at The Motley Fool (if you’re a novice, The Motley Fool is a great place to learn more about the markets). You can use one of any number of play portfolios to hone your skills and get used to the stock market (without the pesky “losing money” part).

The Regular Joe (or Jane)

The Regular Joe is someone who likes to check up on stocks every once in a while (whether that’s once a day, once a week, or once a year) and keep up to date on the financial news. He or she has the time and inclination to read the news but simply isn’t terribly interested in everything that’s going on in the financial word. The solution? Try a “Lazy Portfolio.”

A lazy portfolios are buy-and-hold portfolios that consist of low-cost & no-load index funds. They are the bane of Wall Street and brokers hate them. They are created by financial experts and they perform quite well. Here are a few of the cooler sounding ones:

• Couch Potato: 50% Vanguard 500 Index & 50% Vanguard Total Bond Fund Index
• Sophisticated Couch Potato: 75% Vanguard 500 Index & 25% Vanguard Total Bond Fund Index
• Margarita: “One part total stock index, one part international stock index and one part inflation-protected Treasury securities.” (if you went Vanguard, that’d be 33% Total Stock Market Index fund, 33% Total International Stock Index fund, and 33% Inflation-Protected Securities Fund)
• Coffeehouse: 40% Intermediate Bond Index, 10% in each of Total Bond Index, S&P 500 Index Fund, Large-Cap Value Fund, Small-Cap Fund, Small-Cap Value Fund, International Fund, and a REIT index fund.
• No-Brainer: 25% in an S&P 500 Index Fund, Small-Cap Fund, European Stock Fund and a Total Bond Market Fund.

There are plenty of other options out there, and you don’t have to go with Vanguard, but those should get you started.

The Gambler

Everyone has a bit of gamble in them, some have more than others. I used to play quite a bit of online poker and blackjack in college, so I know that feeling. I know that rush of seeing good things happen and the despair when bad things happen (all too well), so I’m familiar with that mentality. I don’t gamble much anymore but it’s easy for one to fall into the trap of playing a little too much with the investment portfolio. So many of the same features of the stock market mimic the casino. Your money isn’t “real” money, it’s just numbers on a screen. Stock prices can jump and fall so quickly (even more quickly once you start talking options and derivatives) that it can give you that rush. (I wouldn’t recommend for gambling addicts!)

The solution is to go “Regular Joe” (i.e. Lazy) on 90% of your portfolio and allow yourself to “play” with the remaining 10% (any safe percentage, or absolute number, will do). With the 10% you can put it on individual stocks, experiment with options or futures or even foreign exchange, and feed desire for excitement.

The Compulsive Ticker Checker

When I first started working, I checked Yahoo! Finance every half hour while I was at work. I had some individual stocks in my Roth IRA and I was checking them every few minutes just to see what was going on. I did it because I didn’t really have much else to do at the time and it was just a way for me to read up on news, check to see if anything crazy was happening, and otherwise just kill time. The real solution to a compulsive ticker checker, if you want to reduce risk and still maintain market returns, is to select broad market index funds and add them to your online portfolio tracker. You’ll have plenty of information in those index fund news articles to keep you busy all day. Or get a hobby that isn’t investment related!

The Overworked

If you’re the type of person who wishes there were twenty-eight hours in a day, then you know that the reason your investments are being neglected is because you simply have too much on your plate. Rather than adjust your life’s priorities so you can invest properly, you should adjust your investments to match your life’s priorities. If you’re way too busy to look at your investments, even just once a year, then go with entirely lifecycle or target retirement funds. They are simply mutual funds comprised of other mutual funds, designed for a specific retirement date in mind. They handle all the allocations, all the re-balancing, and all the headache you simply don’t have the time to do yourself. They are also very affordable so you aren’t paying out the nose for someone to manage your investments.

Selecting the right style is crucial to ensuring long term success. If you’re a gambler (or have the itch of a gambler) and try to stick with a portfolio that doesn’t let you satisfy your desire for risk, you’ll end up making bad decisions somewhere once those bottled emotions get uncorked. If you’re overworked and don’t stick with something simple, things will fall through the cracks and your assets will suffer.

Which type(s) are you?

(photo: spencereholtaway)

Ever heard of the Margarita portfolio? How about the Couch Potato portfolio? Or the No-Brainer portfolio? No?

They’re all Lazy Portfolios.

A Lazy Portfolio is one that you can just set it and forget it and relies on low cost index funds or ETFs. There’s nothing particularly special about any Lazy Portfolio, besides their use of low cost index funds, and one isn’t necessarily better than another in all economic scenarios. As with any investing strategy, there are pros and cons. The pros, that it’s simple and you make few decisions, results in cons in that you may become complacent and ignorant of your investment decisions. It’s better to keep it simple and well understood than to make it complex and obfuscated. I’d rather make a choice that turned out wrong than make a decision I didn’t understand.

How They Perform

Paul Farrell of MarketWatch tracks eight Lazy Portfolios each year and in 2008, they have extended their winning streak of beating the S&P 500 for the sixth year (on a three-year and five-year basis). In other words, having a one of the eight Lazy Portfolios over the last six years has gotten you a better return than the stock market itself. (This year, three of the portolio’s got beat because they had a lot of REIT funds, but they are still besting the S&P over the last few years).

Here are the funds with the best names: (some of which weren’t featured in Paul Farrell’s wrapup)

Couch Potato Portfolio

This portfolio is the brainchild of Dallas Morning News columnist Scott Burns and is as simple as they come. All you need is 50% in the Vanguard 500 Index Fund (VFINX) and 50% in the Vanguard Total Bond Fund Index Fund (VBMFX). That’s it. You can go a little more aggressive with the variant Sophisticated Couch Potato Portfolio of 75% in the Vanguard 500 Index Fund and 25% in the Vanguard Total Bond Fund Index Fund.

Margaritaville Portfolio

This portfolio is also another one of Scott Burns’s creations and is the second simplest portfolio with equal parts of three funds: Vanguard Inflation-Protected Securities (VIPSX), Vanguard Total International Stock Index (VGTSX), and Vanguard Total Stock Market Index (VTI).

No-Brainer Portfolio

Created by Dr. William Bernstein, a neurologist known for his work in modern portfolio theory and his book The Four Pillars of Investing, the No-Brainer Portfolio consists of four funds of equal weight: Vanguard 500 Index (VFINX), Vanguard Small Cap (NAESX) or (VTMSX), Vanguard Total International (VGTSX) or (VTMGX), and Vanguard Total Bond (VBMFX) or (VBISX). There is also a No-Brainer Coward’s Portfolio that includes 9 funds.

Coffeehouse Portfolio

This little gem was created by money manager Bill Schultheis, author of The Coffeehouse Investor: How to Build Wealth, Ignore Wall Street, and Get On With Your Life, created the Coffeehouse Portfolio that consists of seven funds:

• 40% in Vanguard Total Bond Index (VBMFX)
• 10% in Vanguard 500 Index (VFINX)
• 10% in Vanguard Value Index (VIVAX)
• 10% in Vanguard International Stock Index (VGTSX)
• 10% in Vanguard REIT Index (VGSIX)
• 10% in Vanguard Small-Cap Value Index (VISVX)
• 10% in Vanguard Small-Cap Index (NAESX)

Those are the cooler sounding ones but there are many many others out there!

(Photo: tanakawho)

Money Magazine recently released the only 7 investments you’ll ever need and, surprise surprise, my favorite firm, Vanguard, was listed first choice for five of the seven. Their founder, John Bogle, was a major proponent of index funds and it shows in their offering, as almost all of Money’s choices were low-expense ratio index funds.

Need another reason to have a mutual fund account at Vanguard? (No, Vanguard doesn’t sponsor this site!)

Blue-chip US-stock fund: Fidelity Spartan 500 Index (FSMKX) because it replicates the S&P 500 with an expense ratio of 0.10% (coincidentally, Vanguard’s version, the Vanguard 500 Index Fund Investor Shares (VFINX) is 50% more expensive with a ratio of 0.15%).

Blue-chip foreign-stock fund: Vanguard Total International Stock Index (VGTSX) because of its solid performance, beating 90% of its peers, and because it’s an index fund with an expense ratio of 0.27%. Another Vanguard fund, the Vanguard FTSE All World Ex-U.S. ETF (VEU), was listed as an alternative.

Small-company fund: T. Rowe Price New Horizons (PRNHX) is an actively managed fund, one of the few actively managed funds they selected, and is “one of the most efficient of the actively managed crowd.” Considering it is actively managed, an expense ratio of 0.8% is pretty good, about half the average.

Value fund: Oh look, another Vanguard fund - the Vanguard Value Index (VIVAX) and its 0.2% expense ratio and a record that trumps 78% of its peers. Value funds go after investments that appear overlooked or beaten down and try earn a little off those cigar butts and dividends, rather than looking for growth potential.

High-quality bond fund: Vanguard Total Bond Market Index (VBMFX) snags this category with a 0.2% expense ratio. Bonds are good to be the rock in your portfolio to give you some grounding as your other investments shoot up and crash down.

Inflation-protected bond fund: This last category was won by Vanguard’s Inflation-Protected Securities Fund (VIPSX) and it’s 0.2% expense ratio (Vanguard’s index funds are ridiculously efficient). “Among TIPS funds, Vanguard Inflation-Protected Securities has several things going for it, including lower costs and better management than you would get if you assembled your own TIPS portfolio. While the fund returned 6.6% over the past five years, you shouldn’t expect it to make a pile of dough. Its job is to protect the money you already have.”

We live in a society where we are taught that we should try to be the best. Be #1 in your class, rise through the ranks of your company and be the best that you can be, be the fastest, smartest, or strongest, best best best. While I agree, we should always try to be the best, the point of investing isn’t to get the highest return, what most consider to be the best, but it is instead of get the highest return for what you’re willing to put into the process and what you’re willing to risk.

I used to read news articles, annual reports, and all those financial pieces on various companies, trying to glean bits of information and figuring out if I could get an edge over the market. I had the time to do that because I was in college, but now? Forget it, reading annual reports? Scouring balance sheets and income statements? No thanks.

So, that’s when mutual funds come into play. You have research without all the hard work of research. You also have diversification (hopefully they’re not diversifying in the general population’s understanding of diversification and actually diversifying and taking into account co-variance and blah blah) without the hard work of actually calculating anything out. The only downside of mutual funds is that very few exceed the market and all are more expensive than index funds.

So, that’s when I moved onto index funds and target retirement funds. The problem with index funds is the geographic and equity exposure. If you’re in an S&P 500 Index fund, you’re in all stocks and you’re in all USA. USA is a wonderful country, man I love it here, but our dollar is getting pummeled because of the trade imbalance and the nearly universal hatred of our President (I voted for him twice, thank you very much), and so you don’t want 100% national exposure. So I’m in target retirement fund to get out of all equity and I’m also in some emerging markets to give me some exposure to EAFE (Europe, Australasia, and Far East).

The beauty of the index fund and target retirement funds is that they are cheap, they are easy, and they will give me at least the market average in returns every single time. The expense ratios are generally tiny for index funds and relatively low on the target retirement funds (not so on emerging markets). In terms of easy, they require no work on my part. I can do something else with that time, even if it is lounging around doing absolutely nothing and being worthless. As for the market average returns, well I think the index fund really speaks for itself on that one. So really, it’s three beauties at once and I love it.

What would you rather do, throw a ball with your kid or pore over balance sheets and income statements? Would you rather listen to a shareholder meeting or go shopping with your friends? How about enjoying a nice night on the town or checking the latest interest rates? Honestly, I’m pretty sure everyone out there would much rather throw a ball, shop, and enjoy a night out over the alternatives in all three cases and that’s what the driving idea behind advice like “just buy an index fund and do something else with your time.” Honestly, it’s really good advice and that’s why I’m tackling it in the latest edition of the Devil’s Advocate. (The Devil’s Advocate series is a series of posts that tries to argue the other side of “conventional wisdom” or common advice)

There are basically two main arguments against just blindly investing through index funds and they are:

1. Index funds are not without risk.
2. Even though you may not like it, you really should be spending time on research.

1. Index funds are not without risk.
Oftentimes people believe that by picking an index fund you’re going with a “safe” investment because you’ll get what the market returns, minus fees. You won’t beat it but you won’t lose to it, so it represents really the “best” that you can get with as little risk, and effort, as possible. Now, in the full specrum of investing options, to say that index funds are not risky would be wrong. With an index fund, you’re still talking about investing in stocks, which always comes with risks.

If you choose, say an S&P 500 index fund, you also run into the issue of country-specific risk - the United States. Depending on what you think your asset allocation should be, you should consider an international component because putting everything in the US is just as bad, from an allocation perspective, as putting it all in stocks or bonds or art or real estate. There are also other types of risk to consider, outside of stock market volatility and country-specific risk, and you don’t get protection from those by picking an index fund.

Even though you may not like it, you really should be spending time on research.

The part of the advice pundits give about index funds, where you get to spend no time on your investments and get to spend it on other things, doesn’t sit well with me. Certainly, if you want to spend absolutely zero time on one of the most important decisions in your life, your investments, then an index fund is definitely your best choice. However, should you be spending zero time on that in the first place? Probably not considering how much time you probably spend researching the other less financially important things in your life.

You might like it…
This reason doesn’t fit with the two main reasons why going with all index funds might be a bad idea but it’s definitely a “soft” reason why you should consider life outside of index funds. Part of the fun of investing is learning about companies, learning about industries, and learning about other countries and cultures. At the end of the day, you might read a lot of news articles or annual reports about Company X and decide that investing in them isn’t right for you right now, but you’ve still learned a tremendous amount about how Company X does business, how that industry does business, and it could pay dividends down the road. Along the way, you’ll also learn a lot about investing in general and it will help make you a more well-rounded person from both a financial and cultural perspective. Certainly, if investing is boring to you and you don’t ever want anything to do with an annual report or a balance sheet then slogging through them isn’t right for you.

What do you think? Are these reasons against index funds legit or was it a bunch of crap? Do you have any on your mind that trump these? Please let me know!

This a guest post by Raj Dash, a personal finance blogger who writes at World Wealth View.

One mindset that is crucial to increasing your wealth is to stop thinking linearly and thinking in “compound” terms. Previously, I’ve discussed how it’s easy to believe that saving $50 or $100/month is not much and thus not worth doing. But that is thinking linearly. Let’s look at saving $50/m over 10 years, using a variety of investment vehicles. Fifty dollars becomes a lot more than you’d think. No amount is too small to save, and fifty dollars is a lot easier to save than a hundred, if you’re struggling. Or undisciplined.

Here’s the general plan: stop thinking linearly and save at the highest rates you can find, without paying ridiculous service fees or penalties. Pretty simple plan, right?

Sure, 10 years X 12 months a year X $50 per month is only $6,000. That’s still $6,000 you wouldn’t otherwise have saved but if you leverage your savings by using online savings accounts, money market accounts or funds, CDs, index mutual funds, and maybe later on, stocks or DRiPs (Dividend Reinvestment Plans), you’ll have more than $6,000 saved in the same time period. Or you could eat that $6,000 in extra donuts and coffee every day for the next ten years. You choose.

Online Savings Accounts
Let’s start with an OSA (Online Savings Account), where we’ll put the savings for the first three years. See the spreadsheet I’ve set up for you. With all the competition right now in the OSA market, interest rates keep changing. Which one you choose depends on whether you think you’ll be taking money out, or even adding extra contributions in. Some OSAs have a minimum balance requirement, and a long list of service fees if you don’t maintain that minimum. Here’s a list of the best high yield savings accounts.

To make it simple, let’s say that the interest rate on your OSA is 4%, compounded daily, no minimum. That means the %APY (Annual Percentage Yield) is (1 + (0.04/365)) ^ 365 - 1 = 4.08%. In other words, $50 left for a full year will be worth $52.04. Still doesn’t sound like much, but stay with me.

After 3 years, with 4% compound interest, saving $50 each month turns into approximately $1915. Nearly two grand saved, simply for cutting back on some discretionary expenses. What if you were able to add an extra $25/m in the second year and an extra $50/m in the third year? You’d have about $2845. Sounding a bit better? Almost an extra $1000 in the same amount of time, just for being a bit more spending-conscious (and thus savings-conscious).

Now that you have some significant savings - but not enough to retire on - you should consider longer-term deposits at higher interest rates.

CDs, Money Market Accounts or Money Market Funds
These are three types of investment vehicles that people sometimes confuse. Money Market Accounts (MMAs) provide a high interest rate on your balance. Money Market Funds (MMFs) are mutual funds, which are not protected by the FDIC. They tend to keep the same unit value, with fluctuating interest rates.

MMFs will often pay out higher than MMAs, but could be risky. (Although that tends to be rare with MMFs.) The interest from an MMF can usually be rolled into purchasing more units. Some MMFs require a term deposit. Here’s an article that compares money market accounts and money market funds in more depth.

Another term deposit is the CD, or Certificate of Deposit. (In some countries, these are called GICs, or Guaranteed Investment Certificates, but amount to the same thing.) CD term durations are often 90-day or 1-year multiples, and interest rate increases with duration. But because of the term commitment, not everyone likes them. It all depends on your personal needs. If you think you won’t need to spend the money soon, go for the CD. If you can afford a bit of risk, try the MMF. Alternately, you may want to split your investment amongst several choices, to reduce risk yet remain mostly liquid.

Again, if you’ve learned enough discipline after several years to invest long-term, pick a CD. For the purpose of an example, let’s pick a CD that pays at least 4.50% for a 3-year term. Remember that you have either $1915 or $2845, depending on how much you saved each month in years 2 and 3. Plus you’ll be depositing at least $50/m.

Check the spreadsheet, and you’ll see that after the second three years, you’ll either have about $4,120 or $9,020. The $410 savings is if you are depositing only $50/m. The $9,020 is if, each year, you’re increasing your monthly contribution by $25. Thus, in the sixth year, you would be saving $175 each month.

If you’ve got the hang/ habit of saving by year six, you might want to consider buying some stocks or index mutual funds, to increase your yearly return.

Index Mutual Funds and Stocks
Neither mutual funds nor stocks are insurable. So if the value of your investment goes down, the loss is gone, unless you can recoup it in the future with some luck. While you can write off your losses against your income, it’s still disheartening.

Stocks are potentially very risky, and share prices require careful watching. Index funds are less risky, but only if you apply DCA, or Dollar Cost Averaging. This is the act of buying the same dollar value each month of an index fund, thus evening out the unit-price spikes of some months.

Say that when you start, the index fund you purchased was at $21 per unit. Divide the amount of money you are investing (in this case either $4,120 or $9,020). That’ll give you the number of units you’ll own. Then, if you are investing $50/m, you’ll get $50 worth of units at whatever price they’re at in a given month. (Funds allow fractional unit ownership.) So when the price drops, you might still be investing only $50, but you’ll be getting more units. Then when the market rises, the index fund’s unit price rises, so you are getting less units for that $50/m, but your overall index fund value will rise.

It’s hard to say what percentage return an index fund will give you using DCA. In the past, it’s been as high as 11-12% over a long term of 5 or more years, especially for an index fund tied to the Dow Jones Index. Whatever the case, applying DCA on an index fund is likely - but not guaranteed - to give you a better return than a money market account, money market fund, or CD.

Simply for the sake of an example, let’s say 7%. Very conservative. You might do better. I’m making this up, because I have no idea what a fund’s unit price will be each month for the four years remaining in our example. You’ll put your savings from the end of year 6 into an index fund, and contribute at least $50/m.

Thus, with your money in an index fund for years 7-10 (4 years), you’ll end up with about either $8,225 or $24,850, depending on how much per month you are saving. So that paltry $50 a month could be worth over $8,000 in 10 years. Saving a little bit extra in later years might generate nearly $25,000.

Now do you think $50 a month is not worth saving?

Let’s be honest… the average Joe Trade is awful at picking stocks. I am awful at picking stocks (don’t ever listen to my stock suggestions). Everyone I know is awful at picking stocks… but everyone knows what the hot sectors are these days right? During the Internet boom, everyone knew Internet stocks were crazy! Get in on the IPO and get rich! The problem was Joe Trader picked a stock, it tanked, he (or she) was burned, and quit trading all together. Diversification is Joe Trader’s best friend and ETFs/Mutual Funds allow Joe Trader to capitalize on the “hot sector” concept without swinging at the blazing fastball and striking out miserably. ETFs are like fast moving mutual funds because you can trade them throughout the day, whereas with a mutual fund you need to wait until the end of the day. That’s why ETFs are becoming more popular.

Yahoo! Finance has a great section on ETFs (Exchange Traded Funds). Morningstar has a very good ETF section as well. Read them and understand them thoroughly because I’m not going go into them in detail. The main difference is that ETFs have intraday prices and trade like stocks (with commission fees too!) whereas mutual funds are traded using end of the day prices.

Money is rushing into ETFs like crazy, ETF assets grew 47% to $222 billion, according to Morningstar. (Article, requires free registration, use BugMeNot) Why? Because ETFs empower the regular trader and allows them to invest in a “hot sector” with little work involved. Do you believe, like everyone, that Biotech and Energy are hot? Invest in an Energy-ish ETF. Right now they top Morningstar’s lists of great performers.

There are downsides to ETFs, mostly regarding commission fees eating into your return, so do your due diligence. Allow this article to open your mind to the concept of ETFs and what they can do for the average trader. Instead of pumping all your cash into Company X because you believe that sector is hot, you can consider pumping it into an ETF for that sector instead.

There has been some interest in an explanation of how the Vanguard Target Retirement Funds work since I mentioned them in an explanation about Mutual Funds in a past article (read The Beauty of Mutual Funds). In this article, I’ll give you a little explanation of how these funds work and what you might expect from them (past performance is not an indicator of future performance!).

They’re in the asset class titled “Lifecycle” by Vanguard and several other brokerage houses have very similarly structured, lifecycle mutual funds (Fidelity has the Fidelity Freedom Funds if that rings a bell). The concept is as the target date draws closer, the fund will invest in increasingly stable investments that have higher yields. Vanguard recommends the lifecycle funds for those seeking “an all-in-one retirement portfolio that automatically grows more conservative as their expected retirement date nears…”

In looking at the fund’s performance and yield, the trend behaves as you would expect. The Retirement Income (which you would purchase if you are already retired) has the highest yield of 3.75% and the lowest average annual total return of 3.96%. The Retirement 2045 (the one with the farthest horizon) has the lowest yield at 1.34% and the highest average annual total return of 9.12%. The remaining funds trickle in between the two at rates you’d expect given the risk characteristics of the funds. And performance since inception? The same trends you’d expect are reflected with the Income coming in at 6.85% and the 2045 coming in at 15.79%.

The Target Retirement funds are simply holdings, in varying percentages based on risk tolerance, of other Vanguard funds. The table below is a percentage of holdings as of 1/31/05 of several of the funds.

As you can see from the table, the Income and 2005 are more conservative than the 2045 and even the 2045. The first two don’t touch Europe and the Pacific while the 2045 has nearly 20% overseas.

So we’ve talked about their performance, but what about their expense ratios? Each one clocks in at 0.21% to 0.22%, which is low, about on par for index funds. Look at the Vanguard 500 Index Fund has an expense ratio of 0.18%, you can be pretty confident that Vanguard isn’t fleecing you on fees for these Retirement funds. Now, these funds are “Funds of Funds” which in some cases may mean the expense ratio listed is charged on top of the expense ratios of the underyling funds. This is not the case with the Target Retirement funds, the expense ratio is the weighted indirect expense ratio. There is a footnote in the prospectus that does state “Although the Fund is not expected to incur any net expenses directly, the Fund’s shareholders indirectly bear the expenses of the underlying Vanguard funds in which the Fund invests.”

Again, if you are interested in these or other Vanguard funds, request a prospectus! Read all about it before you invest and see if they’re for you. And please don’t read my views on these funds as a recommendation to buy into them, I’m just boiling down all the facts available on Vanguard’s site in one easy place. And I invite one and all to comment on my thoughts of the Target Retirement funds (too conservative even with the 2045?) and look forward to them.

The two tenets of investing in the stock market are: “Diversification” and “Buy Low, Sell High.” Simple in spirit, difficult in execution. Mutual funds help you with the first rule of “diversification”, but you’re on your own with “buy low, sell high.” You’ve probably heard of mutual funds before and chances you may even own shares in a mutual fund, but do you really understand how they operate? What’s the load on your fund? Who is the investment manager and what is his or her track record?

A mutual fund is technically a company that holds a portfolio of investments; sometimes people refer to the mutual fund as the portfolio itself. The distinction is minor and not terribly important, but for clarity’s sake the fund actually refers to the “company.” A professional investment manager who manages the various securities held by the fund in its portfolio, that’s how a fund brings “automatic” diversification, runs the fund itself. When you invest in a fund, you’re purchasing shares of the company just as you would with the shares of any other public company.

What does a fund’s load actually mean? Well, it’s how much it costs for you to buy shares of the fund. The load goes to the salesperson as commission for their hard work (read this article for great questions to ask that broker, courtesy of AllThingsFinancial). A fund with a load can be front or back loaded, referring to when the charge is actually incurred. Front-loaded funds charge when the shares are purchased and back-loaded funds are charged when the shares are sold. There are a lot of no-load mutual funds out there where the fund charges 0% as a sales fee. A load charge of around 3.5% is considered low-load and they can get as high as 8.5%.

You decide to go with a mutual fund because you want diversification and each fund publishes a prospectus where they explain the goal of the fund and how they intend to meet that goal. For example, the Vanguard Target Retirement 2045 invests in other Vanguard funds with a strategy “designed for investors planning to retire in or within a few years of 2045.” The idea is to be riskier now and more conservative as 2045 rolls around. So, if you’re planning on retiring in 2045 and want someone to manage your portfolio so it’s risky now and conservative later, then go with 2045. A popular choice for many is to simply find an index fund that matches something like the S&P 500 so they’re guaranteed to match the market. Vanguard has been known to be very good with these index funds since their fees are much lower.

In addition to the direction of the fund, the prospectus will tell you what the fund’s benchmark is. A lot of them pick the S&P 500, sometimes the NASDAQ or even the Dow, but I’ve never really felt that this piece of information was terribly important. I mean if the market is down and the fund is down less, that’s good and the benchmark will tell you that. Also, when you make those sort of comparisons you’re looking at snapshots in time and not the overall trend. So benchmarking can be deceptive and I always look at them with a grain of salt.

I hope this served as a good, albeit brief, introduction to mutual funds. It’s a nice way to get involved in the stock market if you’re not already or it’s just some good information about what your 401k is doing (since you’re probably investing in funds in your 401k).