Part 9 - Automatic

If you haven’t read Parts 1 - 8 of this series, you may find it helpful to go back and read through them. Please leave any question, comments, or suggestions in the comments at the bottom of each post, or email me with the contact page. Thanks!

Mutual Funds

We talked about diversification between asset classes in the last lesson, but now we should talk about diversification within asset classes. The idea here is to buy several investments within each investment class to protect yourself against major losses by one of your investments. Because diversification within each asset class can be a real pain in the butt to do by buying individual stocks or bonds, most investors use mutual funds to easily diversify. A mutual fund is just a basket of several hundred or thousand stocks (or bonds). Buying one share of that fund means that you're actually buying a tiny fraction of a share in each of the stocks held in that fund, making diversification much easier. Funds come in two flavors:

• Actively-managed funds - This is where a fund manager actually decides what stocks or bonds to purchase in the fund
• Index funds - These funds buy and sell stocks to match an index, or a large basket of stocks designed to track the overall performance of the market, or segments of the market

Some of you may be wondering when we'll start talking about stock-picking and how to evaluate that "hot stock tip" that your friend passed you at a party. In short, we're not. The reason is simple: you're not good at picking stocks. A few of you might be, but the dirty secret of the financial services industry is that something like 75% of all actively-managed mutual funds UNDERPERFORM the market. Keep in mind that the managers of these funds are usually paid six and seven figures (or more) and have spent their entire professional lives trying to learn how to beat the market. If 75% of them can't do it, you probably can't either. Not to mention the fact that picking stocks is time-consuming and complicated. Fortunately, there's a better alternative: index funds.

Oh, one more thing: if you know someone who tries to insist that they consistently beat the market picking individual stocks, it's extremely likely that they either haven't been investing long enough to see a market correction (3 - 5 years or longer) or they don't keep very good track of their gains and losses. Just like gambling, we tend to subconsciously downplay our losses and enhance our gains in our mind, leaving us with a feeling that we did better than we really did.

Before we dig into index investing, let me suggest that if you really want to pick individual stocks, you set aside a certain portion of your portfolio for that purpose (no more than 10%). Keep careful records of your gains and losses for the stocks you pick. If after 10 - 15 years you've consistently beat the market, think seriously about a second career in finance :-)

Index Investing

An index is a basket of stocks designed to help track the performance of market sectors, or the market as a whole. For example, the S&P500 is one of the most common stock indexes and is composed of 500 of the largest publicly-traded American companies. The Dow Jones Industrial Average ("the Dow") is another common index and is composed of 30 of the largest and most stable American companies from different sectors of the economy.

Index funds buy and sell stocks to match the stocks that make up an index. So an index fund that tracked the S&P500 would buy the 500 companies that make up the S&P500. Why is this important? For a few reasons:

• By buying the entire market (or entire sectors), you effectively guarantee that you'll match the market's (or sector's) return.
• Because there's no Harvard Business School graduate earning $10 million a year and running a large research staff that costs many more millions, the expenses for an index fund are almost nothing. Many index funds have expense ratios of 0.25% or less, compared with 2-3% for many actively-managed funds.
• Because the composition of the index funds doesn't change very often, there's very little trading costs, as compared with a mutual fund that is buying and selling stocks all year long, which costs money, and has a direct impact on your bottom line.

You might be wondering just how big of a difference a percentage or two makes. After all, if you make 9% instead of 11%, is it really that big of a deal? Here's an example scenario:

• You invest $500 / month at 9% for 40 years, at which point you'll have $2.3 million.
• You invest $500 / month at 11% for 40 years, at which point you'll have $4.3 million.

That 2% of interest cost you $2 million over 40 years. There is an entire industry out there that thrives on people's ignorance of this point and how much turning your money over to a professional money manager will end up costing you in the long run. To those that work in this industry, or hope to, let me encourage you to either be honest and tell people that you'll likely underperform the market, or be one of the 25% that doesn't ;-).

Which Index Funds?

Index funds come in tons of different sizes and shapes. There are index funds for different market sectors (energy, telecom, etc), different market capitalizations (small cap, large cap, etc), and different parts of the world. However, I'm again going to eschew the traditional approach of making you sort it out for yourself and give you my opinion of what you should invest in. The following are indexes for the different sectors that you might wish to invest in, with the symbol of an index fund that tracks that index in parentheses.

• US Large-cap index: S&P500 (Symbol: SPY)
• US Small-cap index: Russell 2000 Index Fund (Symbol: IWM)
• US Total market index: Russell 3000 Index (Symbol: IWV)
• US Bond Market: Lehman Brothers U.S. Aggregate Index (Symbol: AGG)
• International Broad Market: EAFE (Symbol: EAFE)
• Emerging Market Index: EEM (Symbol: EEM)

All of the funds above are ETFs, or exchange-traded funds. This just means that you can buy them through pretty much any broker. A couple of notes:

• If your 401k does not offer these options, they probably offer something similar. Your 401k administrator may be able to help you. Just tell them the index you'd like to track with your index fund and they should be able to point you to the right choice.
• If you are fortunate enough to have enough assets to open an account at Vanguard or Fidelity and plan to invest in their index funds, the above won't apply to you. However, both Vanguard and Fidelity offer a wide variety of index funds that are essentially equivalent to the above and offer some of the lowest expense ratios out there. Give them a call and they should be able to help you get setup with the right funds according to your asset allocation plan.

Task: Setup your automatic investment plan in the index funds of your choice.

Take your asset allocation plan that you created in the last chapter and match each category to the appropriate fund above. Then log into your broker of choice (Fidelity, Vanguard, Sharebuilder, etc) and create an automatic investing plan. You should be able to specify a certain amount to pull from your bank account each month and what percentage of that money to invest in what stocks or funds. Once you're all set, you'll just need to remember to ensure you have money in the account. I've always found it helpful to set my automatic investing plan to pull money from my bank account the day after payday, to ensure that the money comes out before I have a chance to spend it on other things. You may also want to set a reminder on your calendar.

Disclaimer: I am not a professional financial adviser. All information herein is provided in good faith. It is not intended to be, and should not be relied on as, a substitute for independent legal, financial, tax or other professional advice. Readers should seek appropriate legal, taxation, accounting, investment or other expertise in their local and overseas jurisdictions.