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Why you need more than an index fund

Index funds are all the rage today. There are a lot of very good reasons why, including the fact that they’re easy to “manage”, have low expense ratios, and are a good mix of risk and reward. They also were the alternative to turn to after the recent backlash against under performing mutual funds.

Unfortunately, simply putting your money in an index fund and calling it quits is not going to get you the best returns. By spending just a little more time researching the subject of portfolio allocation, you can increase your returns for the same amount of risk.

How? There is an excellent report by Hogan Financial Management that details this, which I’ll be using as a source for this information. It starts by comparing portfolio management to being a master chef. A chef doesn’t simply choose a packaged mix and throw it in the microwave. He instead creates a beautiful dish from a mix of carefully chosen individual ingredients.

So instead of having Hamburger Helper for dinner, the food version of an index fund, let’s instead look at a way to more carefully construct your portfolio. This assumes you have a somewhat standard portfolio of 60% stocks, invested in the S&P 500, and 40% intermediate term bonds (many readers here have a higher percentage of stocks, but the same theory still applies). This portfolio had an average return of 13.66% from 1975 to 2000, with a standard deviation of 10.5%.

Standard deviation is a simple way to measure the risk of an investment like this. A higher deviation means a larger departure from the average; in this case that means spikes in the gains or losses of an investment. Listed below are changes that can be made to increase the returns of such a portfolio:

1: Shorten the maturity of bonds
While it is true that longer term bonds often have higher interest rates than shorter term bonds, the risk of being locked into a long bond that may decline in value is not worth the small gain of higher interest.

This step actually reduces the overall potential gain of the portfolio down about 0.5% to 13.27%, however it greatly reduces risk by 1.5% (in terms of standard deviation). This allows you to take risk in places that offer higher rewards.

2: Add small capital stocks
There are two reasons for this. First, this is a step towards diversification. The S&P 500, while a solid index fund, is mostly focused on larger-cap stocks. Secondly, while small-cap stocks are higher risk, they can also offer much higher rewards than the risks of a longer-term bond mentioned above. In fact, small-cap stocks often go up when the S&P stocks go down, which provides a nice balancing element that can lower portfolio volatility.

This step increase the portfolio’s return to 14.43% and standard deviation to 11.68%

3. Add value stocks
Value stocks are stocks which are current a bargain for what they should actually be worth. This often happens, for instance, when the magical number that investors (or companies) place for a quarterly profit is not met. Value stocks are usually held for a period of a few years, which give them time to recover from the low price you bought them at, and in turn give a solid return. In fact, value stocks outperformed the S&P500 index 92% of each rolling 20-year period since 1963. They also further diversify your portfolio in that value stocks have returns that differ from the average S&P 500 stocks.

Adding value stocks increases the portfolio’s return to 14.95% and decreases standard deviation to 11.36%

4. Add international stocks

With globalization having a bigger and bigger impact on somewhat equalizing international markets, adding international stocks still is an excellent way to diversify your portfolio to reduce risks. It may not impact your gains much, but common sense tells you that investing all of your money in one nation is riskier than spreading some of the money abroad.

Adding international stocks decreases the portfolio’s return to 14.93% and standard deviation to 10.08%.

By taking these steps listed above, we have increased the return of $1 invested in 1975 in the original portfolio from $27.93 to $37.26 – and have decreased risk at the same time!

Do not be a slave to a single index fund, or feel as though because you are not trained in the stock market that you can’t take steps to improve the returns on your portfolio!


11 Comments so far
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[...] Why You Need More Than An Index Fund This argument is good in one way and weak in another; my counterpoint would be that you should just own multiple index funds and balance it yourself. (@ money mythos) [...]

[...] Why You Need More Than an Index Fund [...]

Excellent point… you may think you are diversified, but having just one fund can’t cover everything.

[...] Mythos talks about why you need more than an index fund. I completely agree. One fund can’t completely diversify [...]

[...] Graham’s Intelligent Investor. The same logic applies to real estate. -The Money Mythos presents Why you need more than an index fund, “you can increase your returns for the same, or less, risk”. If you have all your your money [...]

[...] Why You Need More Than An Index Fund by The Money Mythos [...]

There are index funds available to cover small cap stocks, mid cap stocks, value stocks, international stocks and more. It is misleading to equate indexing with what you call a standard portfolio. You can put together a very sophisticated portfolio using nothing but index funds. See for example
http://www.ifa.com/portfolios/p040/index.asp

Yes, my post was more geared at people who put their money into a single popular index fund that covers, say, the S&P or Wilshire 5000. Pretty much all of the steps I mentioned above can be done through index funds.

Daniel, your point was good, but Jon, you are talking about diversification beyond just large domestic companies. I think it is useful to take diversification two steps further. Use both index and actively managed funds and do not buy all your funds, even your index funds, from the same fund company. For each category you want to invest in, find the best fund and include both index and managed funds across your mix and you will also reduce the risk of investing in a company or manager that under performs. This is what I am researching on my site http://www.wyliemoney.com and specifically looking into here!

[...] Why you need more than an index fund, submitted by The Money Mythos [...]

[...] your portfolio in an index fund and leaving it at that (you can read my rebuttal to that approach here) also are fans of buy and hold. However, even one of the most well known investors who has preached [...]



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