Stocks and bonds are the two largest constituents of index funds, whether those funds are exchange-traded funds or mutual funds.
In chapter seven of “Index Investing for Dummies,” author Russell Wild led readers through many of the pros and cons of investing in stock (equity) index funds.
Funds based on stocks provide growth, which means staying ahead of inflation and having your portfolio post real increases in value. Of course, stock prices don’t always grow; sometimes they get into trouble and decline. Interestingly, Wild reported he was writing this chapter in the third quarter of 2008. As he was writing, the S&P 500 (through the SPDRÂ S&P 500 (SPY, Financial)) was down 11%; as we know, in hindsight, it had much, much further to fall.
While that risk cannot be eliminated, it can be minimized by diversifying with bond index funds and commodity index funds. The author also focused his attention on the two types of risk that apply to stocks and funds based on stocks:
- Nonsystemic risk is essentially company risk. This occurs when an individual company gets into trouble, through its own mistakes or changes in its environment. For example, Sears (SHLDQ, Financial) was hit by both, first because it was somewhat starved for capital by its owners and second because Amazon (AMZN, Financial) and other online giants began taking market share from traditional retailers like Sears.
- Systemic risk refers to price losses that occur when the full economy loses steam. For example, bad mortgage lending and securitization practices in the mid-1990s led to the collapse of several prominent investment banks. That, in turn, scared a lot of money out of the stock market as a whole and gave us the 2008 financial crisis.
Wild observed, “Investing in stock indexes wipes nonsystemic risk off the map. When you are an index investor, you free yourself from the stupidity of individual CEOs and the vicissitudes of a fickle investing public that may like a certain stock one day and not the next.”
Index investing, then, eliminates nonsystemic risk, but does nothing to reduce variability from systemic sources. What does help, though, is the passage of time. Wild argued, “But here's the good news: Over the long run, you get compensated for systemic risk.”
Taking that a step further, he wrote: “The higher the risk, the higher the return — as long as we're talking about systemic risk!” In using the phrase “high risk,” he is referring to securities such as small-cap stocks or emerging market stocks, while using blue-chip stocks as a proxy for lower risk. On the other hand, there is no risk reduction for an asset class that is subject to nonsystemic risks.
The author uses the standard 10% average annual return for S&P 500 stocks, but that figure requires a couple of caveats. First, after inflation the figure will be close to 7%. Second, the S&P 500 is a collection of very big companies, so we don’t really have a sense of the full market.
Still, his point remains valid. Investing in stock fund indexes will help investors grow their savings after inflation. Keep in mind, though, the old adage that past performance is no guarantee of future performance.
One of the ways in which investors, including index investors, minimize systemic risk is by reducing the proportion of stocks and stock funds as they grow older. Because younger investors have more time to recover from stock losses, it is said they can take more risk than older investors. A rule of thumb for estimating how much of a portfolio should be in stocks is 100 minus your age. For example, a person aged 55 would hold 45% (100 – 55) of her or his holdings in stocks, while a person aged 70 would hold 30% in stocks.
There are also basic tactics that allow investors to reduce their systemic risk, including:
- Invest for the long term: For more than a century, the market has gone up. But in short periods, say two to three years, it has gone down as well as up.
- Minimize your tinkering: Every time you buy or sell a stock, you incur costs and those costs will reduce your returns. Remember that compounding works both ways.
- Don’t pay more than necessary: Watch the fees (management and transactional) you’re being charged as they, too, will compound down and reduce your returns.
- Diversify as much as possible, by geographic regions, by capitalization and by value and growth stocks.
- Beware of taxes: When possible, use tax-advantaged accounts or outside of them, trade as little as possible.
- Take only appropriate risks, remembering to avoid nonsystemic risks while minimizing systemic risks.
- Balance your portfolio: In addition to stocks, have bonds, commodities and cash in your portfolio.
- Buy low, sell high: Try to buy when others are selling and vice versa. Remember Warren Buffett (Trades, Portfolio)’s advice to be “fearful when others are greedy and greedy when others are fearful.”
- Don’t ignore your portfolio: Even investors with strong portfolio strategies should review their situations periodically. As the author pointed out, as we get older, our income changes and other personal details change over time—and the securities you hold may change too.
Wild concluded the chapter with some of his choices for stock index funds, just before the financial crisis of 2008 took its deepest dive.
In this chapter, he has shown that we can reduce our portfolio risk by eliminating nonsystemic risk entirely and by reducing our exposure to systemic risks. Those are important because stocks are the growth ingredients in any portfolio.
Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.
Read more here:
- Indexing for Dummies: Comparing Mutual Funds & ETFs
- Indexing for Dummies: ETFs and Alternative Indexes
- Indexing for Dummies: Seduced by Big Promises
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