It would be great if we could just pick companies like Amazon, Apple, 3M, or [your favorite growth story here] and invest in those very early on, but we can’t. There is plenty of evidence that highly paid professional investors can’t do that reliably, let alone average investors. Accepting this fact is the first step to a much better investment experience and low levels of investment-related anxiety. 

So what can we do? As we showed in part 1 of our series, we don’t need to be able to pick winners or have a crystal ball to benefit from the stock market. We can leverage the idea that, while fluctuating, stocks have tended to rise in value on average and over time, generating handsome returns for long-term investors. These potential returns can be pursued by investing broadly across stocks, a strategy that goes by the name of diversification. 

Diversify, Diversify, Diversify

There is simply too much risk in picking single companies. Differences in returns across stocks are such that a small number of stocks strongly outperforms the average, while the majority of stocks underperforms the market average. In fact, fewer than 50% of stocks beat short term Treasuries in a given year. The chances of picking the right one year in and year out are stacked against you. 

But you can use the diversity of returns across stocks over any given period to your advantage by spreading your investment across many stocks.  Doing so means that the bad returns of some companies can be offset by the good returns of other companies. The more companies you include, the closer you will get to earning average or market returns. This will help you eliminate extreme risks and smooth out some of the bumps in investment performance over time.

How many stocks should you include? The answer is basically all of them. Investment solutions are available that let you do just that, and at a very low cost. The three golden rules of stock investing are Diversify, Diversify, Diversify.

Choosing Mutual Funds and ETFs

Most individual investors don’t buy stocks directly. They invest in stocks using pooled investments like mutual funds and exchange traded funds, or ETFs. Because putting together and managing a portfolio of stocks requires expertise, time, effort, and a sizable investment, most investors prefer to use a professional manager to do that for them. That’s what mutual funds and ETFs do, they professionally manage a portfolio for you. Unfortunately, given the variety of funds out there, choosing a fund can be even harder than choosing stocks individually. According to the Investment Company Institute or ICI, there were over 11,000 mutual funds and ETF as of December 2019. So, how is one to pick?

Avoid Actively Managed, High Fees, And High Turnover Funds

The first thing we can do is to eliminate actively traded mutual funds. These are funds that try to beat a market index (like the S&P 500) by trying to actively pick winners or by timing when to enter or exit a certain sector or market.  Professional money managers aren’t much better than the average investors at beating the market average. Recent research by S&P Dow Jones shows that over the last 15 years, 87% of funds that actively managed US funds failed to beat a passive market index. Not only that, less than 50% of the funds at the beginning of the 15 year period are available for investing today, because they did not survive for 15 years! Turns out the median life of an active fund is only about seven years. The risk of losing everything after seven years is not what most investors sign up for when they are saving for important goals. 

You can find out whether a fund is active from the prospectus of the fund, which is usually readily available on the manager’s website. However, a good indicator of active management are high fund fees. The median active fund has fees well over 1% per year. You can safely eliminate all funds with total annual fees above 0.65%, which is the 10th percentile across equity funds according to ICI data. 

High fees are also a good indicator to eliminate funds that target a narrow market or don’t have enough diversification (like industry specific funds), and funds that target asset classes that are not appropriate for most investors (e.g. individual commodities). Reading the prospectus sections on fees, investment objectives, investment strategies, and turnover can also help you determine whether the fund is worth considering.  

You don’t necessarily want to eliminate a fund just because of higher than average fees, but the fund must have compelling objectives and strategies for your goals. This is where you may want to consult with a trusted and objective advisor before investing.

Get to know index investing

As we reviewed in part 1, an index includes all stocks in a selected group or category, called a universe. For example, the S&P 500 includes the 500 largest companies traded in the US stock market. The Russell 3000, another index, includes the 3000 largest companies traded in the US stock market. Because there are a total of about 4000 stocks in the US market, the Russell 3000 is more comprehensive as a market index than the S&P 500. The S&P 500 is a better representation of the performance of large US companies. 

Index funds are mutual funds and ETfs whose investment objective is to track a specified index. Their investment objective is the conceptual opposite of an actively traded fund, which makes active attempts to beat the index by picking stocks or bonds.

You can find out if a fund is an index fund in the prospectus, under the investment objectives or investment strategies sections. The way stocks are combined in most indexes is by market capitalization: if company A is twice the market value of company B, it gets twice the weight in the index. 

Index funds are an effective way to build a highly diversified portfolio for your goals. The returns of an index fund should approximate the return of the market or market segment it is tracking, minus the cost it takes to manage the fund. Because index funds don’t have to spend money on the research and management necessary for actively managed funds, their fees tend to be much lower. The median index fund charges 0.33% in fees, and many common index funds charge between 0.04% and 0.12% in fees, a fraction of what active funds charge.

Some Common Indices by Market Segment

The most common index providers are S&P Dow Jones, CRSP, and Russell for the US market, and MSCI, FTSE for international markets.  Some of the most common indices in terms of invested assets are listed in the table below. The goal is not to be complete, but to get familiar with some of the names and the market they represent. Your 401(k) plan or IRA may have fund options that track some of these.

Region	Company Size	Index
US	Total Market	CRSP Total Market Index
		S&P Total Stock Market Index
		Russell 3000 Index
	Large Cap	S&P 500 Index
		Russell 1000 Index
	Small Cap	S&P 600 Index
		Russell 2000 Index
International Developed	Total	FTSE Developed ex-US All Cap Index
	Large	MSCI World ex-US Index
		FTSE Developed ex-US Index
	Small	MSCI World ex-US Small Cap Index
Emerging Markets	Large/Mid	FTSE Emerging Index
		MSCI Emerging Markets Index

There are thousands of indices. However, most investors will benefit from a very broad exposure to different markets, so just look for broad coverage areas, like the table above. For the US, total market indices are preferable. However, even an index like the S&P 500 covers over 80% of the total US stock market value. Stocks of smaller companies are typically riskier than stocks of large, established ones, but have yielded higher returns, on average. International developed indices track the markets of 23 internationally developed countries around the world. Emerging market indices track the performance of 26 emerging market countries. 

A global market index would have approximately 60% US stocks, 30% internationally developed stocks, and 10% emerging markets stocks. These percentages represent the share of each region in the global stock market. So with three funds one can build a highly diversified portfolio containing over 12,000 securities, at a fraction of what the average actively managed fund may charge. 

Additional Considerations

Index investing is common sense investing. All investments involve a certain amount of risk, for which we expect to be compensated by future returns. We can’t eliminate all risk if we want to benefit from higher potential returns. However, with a diversified portfolio we can eliminate extreme risks that go with trying to pick winners and instead focus on earning average market returns, which historically have been substantial. 

Is indexing the best we can do? If all investors held the same portfolio, it would have to be a portfolio with 60% US stocks, 30% international stocks, and 10% emerging markets stocks, like the index approach. That’s because in aggregate all investors have to hold the market, which is roughly split this way. So the market aggregate is a great starting point for the average investor. Deviating from the market may make sense, but whether and how to do it depends on individual needs and preferences. We will describe some general framework for doing so in future posts.

Until Next Time!

Massi De Santis is an Austin, TX fee-only financial planner and founder of DESMO Wealth Advisors, LLC.  DESMO Wealth Advisors, LLC provides objective financial planning and investment management to help clients organize, grow, and protect their resources throughout their lives.  As a fee-only, fiduciary, and independent financial advisor, Massi De Santis is never paid a commission of any kind, and has a legal obligation to provide unbiased and trustworthy financial advice.