Anna Mate

Archive for March, 2010

What if I told you there was a really easy way to invest your Core that involved a minimum of effort, just about guaranteed diversification, and frequently outperformed its competitors? Well, that investment is none other than the dependable, if unglamorous, broad-market index mutual fund (versus actively managed funds, which are designed to outperform the market but often don’t accomplish that goal—especially when it comes to large-cap funds).
The index funds are a type of mutual fund designed to track—rather than beat—a specified market index, such as the S&P 500 Index or the Wilshire 5000 Index. Why invest in index funds? First, they provide diversification. For example, the Schwab 1000 Index closely tracks one thousand of the largest companies in the United States based on market capitalization (and represents about 90% of the U.S. equity market), As a result, one share of the Schwab 1000 Funds represents a tiny portion of each one of those thousand companies, which include almost every industry imaginable. (Of course, if you opt for one of the smaller or more sector-specific index funds, you lessen that diversification. A narrowly focused index fund is not an appropriate Core holding.)
Second, if you subscribe to the efficient market theory, which holds that security prices fully reflect all publicly available information, you understand just how difficult it is to outperform the stock market. According to this line of reasoning, unless you’re an “insider” (in which case you are legally prohibited from trading on this information), there is no way for you to have special information that will give you an edge over other investors. Of course this concept is not absolute, but when it comes to the best-known and most widely followed companies, it is likely close to the truth. As a result, when it comes to investing the large-cap portion of your portfolio, index funds, which are designed to keep pace with the market, make a lot of sense. A third important factor that makes index funds attractive is their low fees. There’s no expensive research team to pay and no high salaried fund manager to compensate. The stocks in the index fund are often simply determined by a computer program that analyzes the index that the fund is tracking, then makes sure that the percentages of the various companies in each match precisely.

When it comes to buying investments, too many of us operate by the seat of our pants, following this tip or that instead of taking the time to talk out and then set up a cohesive investment plan. “You have to look at the bigger picture,” insists one Schwab employee involved with investor education. “Otherwise you’re just throwing the dice.” That’s a good analogy, because unless you establish a solid Core of investments, you’re gambling in a game of luck.
Depending on your tolerance for risk and your time frame, your Core might represent anywhere from 40% to 60% of your stock portfolio (with Explore comprising the balance). For example, a conservative investor might want to allocate 60% to Core, a moderate investor might allocate 50%, and an aggressive investor closer to 40%. In other words, the more conservative you are, the more of your stock portfolio you will allocate to Core and the less you will allocate to riskier Explore holdings. Your Core should be a well-diversified portfolio of U.S. stocks that represent the many sectors (like health care, utilities, technology) and styles (like growth and value) of equity investing as well as both large and small companies. It can be in the form of individual stocks or mutual funds. If you’re a longtime investor, you may well have created a diversified portfolio of individual stocks or mutual funds over the years. But if you’re just starting out, or if you have less than $100,000 to $150,000 to invest in a minimum of 40 to 50 stocks, I highly recommend that you look into buying one or more
broad-based index funds for at least a portion of your Core portfolio. They are by far the easiest and least expensive way to create a solid Core of equities.