Objective View of Stocks, Mutual Funds & Index Funds (Clear Winner?)

Now that you know the desired asset allocation for someone in their mid-twenties, how do you invest to achieve the appropriate percentages? Do you buy one small cap stock, one international stock, and throw a few bucks in a bond, then add money in each until the proportions are sufficient? The answer is unequivocally "No". So what are your options?

You have a few different options; (1) stocks and bonds, (2) mutual funds or (3) index funds.

Option 1: Why do I need sixty stocks?

If you decide you want to invest in individual stocks to reach your desired asset allocation then you need to buy about sixty stocks. Why? Because individual stocks carry risk (unsystematic risk) which is added to the general market risk (systematic risk). Unsystematic risk is the risk associated with an individual stock that can wipe out your portfolio gains by a seemingly minor event; product recall, drop in oil price, etc. To reduce this unsystematic risk you must add more stocks, from different sectors and industries, to your portfolio. According to Burton Malkiel in A Random Walk Down Wall Street that requires about sixty stocks, making this option unfeasible for the average investor after factoring in transaction fees.

Option 2: Mutual funds, not so fast...

The problem with individual stocks is diversification, so let's look at the ultimate diversification resource; mutual funds. There are about 7,707 mutual funds available (plenty for you to choose from) in the market today which contain anywhere from fifty to hundreds of stocks and bonds. Perfect, the funds are diversified enough to virtually eliminate all the unsystematic risk. Not so fast...how much does it cost to hold a mutual fund? According to Ty Bernicke in his article the average cost is 3.17%/year. Doesn't seem so bad, right? WRONG! Let's look at an example from Tony Robbins new book Master the Game: 7 Steps to Financial Freedom to show you how detrimental this is to your future earnings.

• Three friends, Jason, Matt and Terry, all invest $100,000 at age 35. They receive 7% return on their money and don't touch it until they're 65 (30 years). The only difference is the amount each friend pays in fees; Jason pays 3%, Matt 2% and Terry 1%. How much of a difference can a few percentage points really make? The results may astonish you. At 65 each friend has the following;
  • Jason - $324,340
  • Matt - $432,194
  • Terry - $574,349

That's 77% more money for Terry, compared to Jason, with the only variable being the fees.

If you don't believe fees can be this destructive to your investments see Vanguards' tool that allows you to adjust the annual expenses and rate of return of a theoretical $10,000 initial investment.

Another deterrent from investing in mutual funds is their success rate. According to Robert Arnott in a twenty year study of 200 actively managed mutual funds, only eight beat their index, meaning 96% of the mutual funds underperformed. Investors Caught with Stars in Their Eyes is a WSJ article that also shows mutual funds poor track record. The article studied 248 five star mutual funds for ten years, discovering after the ten year period only four kept their five star rank, that's a lousy 1.6%! Each fund is given a one through five Morningstar star rating with the stars indicating the funds performance compared to similar funds; more stars, better performance of the fund.

Is it any wonder why people have trouble reaching financial freedom when they give 50-90% of their returns to the fund manager in fees, or choose a fund that has a single digit chance of beating the market? It doesn't take an MBA to see this option is out.

Option 3: Index funds, so boring they work.

Vanguard founder Jack Bogle, when asked about his investing methodology, simply stated, "Be bored by the process but elated by the outcome." Index funds are about as boring as you get; they match or track the stocks/bonds of a particular market index (S&P 500 Index for example) with little portfolio turnover (selling). In actively managed mutual funds,the administrator is buying and selling stock/bonds to outperform the market index, whereas an index fund is only trying to mirror its particular index or benchmark. Since there is little to no portfolio turnover in index funds the index fund fees are a fraction of the mutual funds fees. Vanguard is well known for having some of the lowest fees in the industry, 0.19% compared to the industry average of 1.08%.

Are index funds available for stocks, bonds, real estate, and cash portions of my portfolio? The answer is yes. There are various index funds available for each part of your portfolio. You can build your entire portfolio from index funds, and as I show you above, you should. Search for an index fund in your online brokerage service, they will have graphs, charts and tables showing you the details of the index, and if your not 100% sure then call and speak with someone in customer service, that's what they're there for.

Let's recap;

• Unsystematic risk, which could cripple your portfolio returns, can be eliminated through diversification.
• Mutual fund fees will, over time, completely devastate your portfolio returns; they are the difference between financial security and financial freedom.
• Mutual funds have an extremely low chance of outperforming the index over time.
• Index funds are the most lucrative vehicle to maximize gains and minimize fees, helping you reach your financial goals sooner.