Welcome back, Treehuggers! Let’s just get cracking where we left off — about half way through an introduction to each of my PDQ Principles. Today, I’ll be tackling the “D” in “PDQ” — Diversification.
If you need a quick refresher on what we’ve discussed up to this point, you can check out an overview of my Introduction to Pops’ PDQ Principles and my deeper dive into the first principle — Patience. And remember, any words that appear in red below, will be followed by a brief definition.
Behave your way to success.
As far as ole Pops is concerned, the key to a small investor’s success is simplicity. In my younger days, I learned the hard way that building a complicated investment portfolio often leads to confusion, unnecessary expense, worry, and the propensity to second-guess choices.
And here’s another zinger. Wise investing…it’s purely BEHAVIORAL.
Let me explain.
A great deal of money is lost when investors “bail out” early in a major downturn — not necessarily because they’re saddled with a poor investment, but because nerves or impatience get the best of them. Whether decisions are made due to fear of a loss in a declining market or the fear of missing out on the next big opportunity, they’re rooted in compulsions. If you can avoid these compulsive behaviors and practice patience, you’re on the right track.
In other words, make a plan and stick to it.
My plan? Consistently save and invest on a continual, scheduled basis. And pay no attention to markets surging up, or down. Stake out a position and stay put.
A diversified investor is a happy investor.
Defined by Webster’s as “reducing portfolio risk by purchasing a wide range of equities and/or bonds from different industry groups”, diversification is one of Pop’s key principles for good reason. Without it, you invite in more vulnerability.
For example, if you only buy the stock of your employer — particularly, an employer who also contributes company stock instead of dollars to your 401(k) — all those eggs in one basket might backfire on you. As a Houstonian, the rise (and infamous fall) of Enron still stings, and many good people lost their life savings when they invested most, or all of their dollars in a company that many deemed unsinkable (kinda like the Titanic).
Index Funds: Making Diversification Easy
To simplify the “D” of PDQ investing, let’s discuss, for a moment, index funds and some reasons to consider investing in them. The S&P 500 Index Fund¹ — a low cost way to gain broad exposure (diversification) in the U.S. stock market — creates exposure to 500 of the largest U.S. companies, spanning many industries. Collectively, these companies account for about 80% of the U.S. stock market’s value.
Recent history has proven that low-cost index funds (unmanaged funds) result in superior yields (returns) for small investors, even compared to the big boys: pension funds, institutions, and the high-hat folks who employ those pricey financial wizards (or “Wazoos” as I like to call them).
And you just can’t beat the price. Index fund fees are as low as it gets. For example, a 90% mix of stocks and 10% short-term bonds purchased through (Wazoo-free) Vanguard result in annual operating fees of just 0.043% of the account balance (assuming you invest in the least expensive variant of the funds). That’s $43 per year per $100,000 of investment.
The average “Wazoo-managed” funds are 20 times more expensive.
Vanguard is the world’s largest provider of mutual funds. Noted for popularizing index funds and driving down costs in the mutual fund industry, Vanguard is owned by the funds themselves and, as a result, is owned by the investors in the funds.
Just the facts, ma’am.
The S&P 500 Index Fund, which employs a “passive investment strategy”, seeks to replicate the performance of the S&P 500 by investing all or a substantial amount of its total net assets in S&P 500 stocks.
Years ago, I personally invested 10% of my pennies in short-term government bonds and 90% in a very low-cost Standard & Poor’s 500 Index fund to establish my core investment portfolio.
Maybe you’re not ready to do the same? It’s certainly your call, but you might consider this: In 2016, two-thirds of active managers (Wazoos) underperformed the S&P 500 Index¹. And during the most recent fifteen years, more than 90% of active managers underperformed their benchmark indexes. In short, most passive index investors (like yours truly) earned yields superior to those attained by other investors.
¹The 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’s one of several indicators of the strength or weakness of the total market — a representative sample, if you will.
If today the S&P Index is 2600, and a year ago today it was 2200, you can use it to assume that today’s broad market is stronger than it was last year. It’s merely one of several indicators of the strength or weakness of the total market — a representative sample, if you will.
Winners in the long game.
In national markets, every share of stock is owned by someone. It follows that if some of these folks consistently do better than average, then others consistently do worse. It’s a zero-sum game where, for every winner there is a loser. If passive index funds (like the S&P 500) consistently outperform actively managed funds, by definition, the index fund investor is one of those winners.
To wrap up, in an investor’s pursuit of diversification, using an S&P 500 Index Fund exposes him or her, historically speaking, to greater gains than most “actively managed” funds. I don’t know about you, but I’m the kinda chap that likes to take the good with the good, and index funds have provided that to me over and over again.
We’ll talk more about diversification in future posts, but hopefully this information has helped you to understand the importance of reducing risk as you develop your own investment portfolio.
My next post will be up soon, and will focus on the “Q” in my PDQ Principles. Until then, thanks for joining us here at YM&TT. We’re real glad to have you!
The content on this blog is provided for information and discussion purposes only. It is not intended to be professional financial advice and should not be the sole basis for your investment or tax planning decisions. Under no circumstances does this information represent a recommendation to buy or sell securities.