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Diversification and ETFs

| February 12, 2019
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I was on Quora the other day and I stumbled across a question which read, “Should I invest all of my money in an S&P 500 index fund?”
My immediate answer was and still is no.

For two reasons.

The vast majority of individuals should not have all of their money in equities. The one exception is/are toddlers and younger whose parents have set up a college savings/retirement account for. They have their whole lives to invest and ride out drawdowns.

Even if you wanted to invest all of your money in equities, it would still behoove you to diversify geographically.

The other thing that came to mind was in reference to one of the other answers to this same question.

The person (the one whose answer I’m referring) said to invest in an index ETF because they are less expensive. To which I agree. He continued by saying that investing in mutual funds is a waste of money because their fees are too high. And this I don’t agree with.

Yes, a decade or more ago, mutual fund fees were crazy high. Well over 1% with some funds crossing the 2% and even 3% mark. Granted there are still a large number of funds with expense ratios over 1%.

I've posted previously about fees, click here to find out more.

However, mutual fund fees since then have come down astronomically. ETFs and mutual funds both have their advantages and disadvantages, and when the talk is about index funds, I don’t think you can go wrong with either.

So here’s how I answered.

I listed three ETFs:

  • Equal-weight S&P 500 index
  • All world ex-U.S. stock index
  • Total bond market index

And three mutual funds:

  • S&P 500 index
  • All world ex-U.S. stock index
  • Total bond market index

Be advised - Unfortunately, I am unable to list the actual funds I recommended, so if you'd like to know what they are, send me an email.

I then told him to diversify and allocate according to his risk tolerance and time horizon. I followed this with a couple of examples. I said that people with several decades until retirement have the ability and good fortune to allocate more towards equities because they have more time to recover from declines in the market.

One more thing I would like to point out that having time to come back from a drawdown should not be the primary factor. Your comfort with the amount of risk you have should be your primary.

If you have 30 years to invest, but you lose sleep every time you see your account dip more than 10%, then you will probably sleep better if you have more of your total portfolio in a bond index fund.

As far as the funds I recommended, the mutual funds are very straight forward. All three with Vanguard. All three with very low expense ratios.

The ETFs are essentially the same with the exception of the equal-weight S&P 500 index ETF.

Of the six funds above, it has the highest expense ratio at .20%.

Let me explain.

Most stock index funds are market cap weighted. This means that the stocks with larger market caps (the value of the company)(market cap = share price x total outstanding shares) make up a greater portion of the portfolio.

For instance, the S&P 500 index fund from above, the top 10 stocks in that fund make up 22.1% of the portfolio. There are 509 stocks in the fund and the first 10 almost make up ¼ of it.
With an equal-weighted fund (as you’ve probably guessed) each stock makes up the same percentage.

In my opinion, this provides a more diversified way of investing the top 500 companies in America.

Be advised that the products provided and the information in this post is for informational purposes only and should not be taken as personal financial/investment advice. Please consult a financial professional for help with your particular situation.

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