Being an index investor mostly means doing very little, despite the possible allure of trading. In chapter 16 of “Index Investing for Dummies” Russell Wild wrote, “An index portfolio, like a planted cactus, doesn't require all that much attention...hardly more than the patience to watch it grow, and some very occasional care.”
He also noted that newer index products (his book was published in 2008) may have made it easier to buy and sell index funds, but easy doesn’t mean investors should. The logic for a buy-and-hold strategy remains simple: .ower costs produce higher returns. It is, “the surest money-making strategy you'll find anywhere.”
However, doing little does not mean doing nothing. There are numerous steps investors can take to protect and enhance their holdings.
Patience
Don’t rush to throw all your savings into the market when the bulls are in charge, and don’t pull them all out when the bears gain control. We’ve all seen the phenomenon multiple times in recent decades, as even index investors chase returns on the upside and run away when the market tanks. Unfortunately, stocks and funds often cost investors more on the upside than they recover on the downside.
Wild argued the best antidote to this is to watch the allocation between stocks and bonds. Stocks increase volatility (and potential returns), while bonds reduce volatility (but dampen potential returns). While an aggressive investor might choose a portfolio with 80% stocks and 20% bonds, a more conservative investor might choose 60% stocks and 40% bonds. Sticking with an allocation ratio ensures index investors don’t get caught up in positive or negative rushes.
Ignore the hype
Index investors without a plan also might be tempted to chase the hot fund of the day, perhaps one with outstanding returns in the past three or five years. But remember that different sectors have different days in the sun and in the shade. Health care stocks have been hot this year, but they might not be next year.
The author recommended we turn off the “noise” coming from television and other media, writing “Don’t buy the hype.”
Rebalancing
Because individual sectors rise and fall, you may find one index fund has outperformed another. In this case, you rebalance, selling off some of the fund that has done well and buying more of the underperformer (or some other fund altogether).
Rebalancing might be done on a calendar basis, such as every 12 or 18 months, or it might be when one fund gets a specified amount higher or lower than its original allocation. Wild offered several thoughts on rebalancing:
- Bigger portfolios can be rebalanced more frequently than smaller portfolios.
- How much do trades cost? The more you pay a broker per trade, the fewer the trades you would normally make.
- Investments in tax-advantaged accounts can be rebalanced more often than investments in taxable accounts.
- Volatility: The greater the volatility, the more often you can expect to rebalance.
- If you add or withdraw money frequently, you may need to rebalance more often.
Most investors adjust their portfolios as they age, generally rebalancing in a way that increases safety (adding bonds) and reduces volatility (reducing stocks). However, that is a general strategy and individuals should feel free to change or disregard it based on circumstances.
For example, as Wild wrote, “Ten years of living expenses in quality bonds pretty much assures you that whatever the economic climate, you'll have enough to pay for the necessities of life.”
He also recommended thinking in terms of total return, not the returns on individual components of a portfolio. This advice came in response some of his older clients who believed they should not sell stock funds, for fear of losing long-term capital gains.
Keep an eye on economic trends
While index investors don’t need to pay much attention to economic trends, Wild does recommend keeping an eye on a few of them:
- The market price-earnings ratio: Wild cites the work of Robert Schiller of Yale, “Shiller's studies and others show fairly conclusively that a low P/E for the overall stock market is a fairly good bellwether that the following decade will show better-than-average returns. And conversely, high P/Es, such as we saw in the late 1990s, indicate that the following decade may see less-than-average returns.”
- The yield curve: Again, a reasonably well-known indicator of the economy’s direction. Normally, investors demand higher yields from long-term bonds because there is more uncertainty. However, when yields are inverted, that is, when short-term bonds have higher yields, the economy may be about to head downhill.
- Reversion to the mean: Value investing is built upon the concept of reversion to the mean or, more specifically, the idea that underpriced assets will eventually rise to their intrinsic value. Of course, overpriced assets also can revert to the mean and burn the fingers of investors who were too enthusiastic about a fund’s future. As Wild noted, we can never know when an asset will return to its mean, but the odds are better than 50-50 that it will eventually.
Don’t take any drastic action in response to these economic indicators, but you may wish to tweak your holdings if one or more of these indicators suggest the economy is about to change gears.
Read more here:
- Indexing for Dummies: Diversify With Alternative Indexes
- Indexing for Dummies: An Introduction to Bond Index Funds
- Indexing for Dummies: Stock Index Funds
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