Wednesday February 15, 2006
Stock Mutual Funds or Stock Index Funds: How Should You Invest Your 401(k) Money?
Corporate America has moved most folks out of “pension programs” [also known as “defined benefit plans”] into a variety of tax-deferred savings programs — such as 401(k) and similar plans. And with today’s "do-it-yourself" approach to retirement investing, there is a lot of confusion and high anxiety.
Many investors question whether "index funds" as opposed to "actively managed funds" are the best choice.
An actively managed fund, commonly known as a "mutual fund", is a pool of money that a team of professional managers invests in a limited number of stocks, bonds, or other assets. The managers "actively manage" such funds — meaning that the managers decide which 20 or 30 stocks, bonds, or individual properties may be the best holdings at any time.
"Index funds", on the other hand, are essentially baskets of stocks, bonds or other assets that represent an entire market or some entire market segment — such as the largest 500 stocks in the U.S. or a basket representing all Asian or all European stocks. Index funds are "passive". There are no human decisions about which specific securities to include. You buy the entire market or market segment.
A number of pundits — including Vanguard’s John Bogle, and Yale University CIO David Swensen — are strong advocates of index investing. And many academic studies show that it is, in fact, hard to beat the results of an index fund over long periods of time. Index funds generally charge very low fees and deliver extremely broad diversification. They’re cheap and can significantly help you reduce concentration risk.
Not surprisingly, more and more investors are flocking to index funds. More 401(k) plans are beginning to offer them. And they include DSPIX [the Dreyfus Basic S&P 500 Index], FSMKX [Fidelity’s Spartan 500 Index], and VTSMX {Vanguard’s Total Stock Market Index].
So are index funds the best way to invest? Do you simply need to make one investment each in a stock, bond, and real estate index fund?
Index investing delivers strong results, but it can also be problematic. When you invest in an index, you buy into a market’s prevailing valuations and the consumer psychology underlying them. Watch out! You can end up owning a huge basket of broadly diversified but speculatively overvalued assets.
When the stock market delivered returns of more than 20% in the late 1990s, investments in index funds soared. But once "irrational exuberance" subsided, investors holding S&P500 index funds suffered mighty losses like every one else. They lost 9.1%, 12% and then 22% respectively in 2000, 2001, and 2002.
Index funds can be powerful investments IF you observe two rules of thumb.
Rule of Thumb #1: Stay away from narrow indexes — like the Dow Jones 30 or the DIA exchange-traded fund — that focus on only few underlying assets. Investing in an "index" of 30 stocks does not provide ample diversification. Instead, aim for a more broadly diversified index fund like VTSMX, Vanguard’s total market index. That’s how you capture the real power of index investing.
Rule of Thumb #2: At the same time, avoid index investing when there is speculative over-valuation built into market pricing. You do not want to buy an index of U.S. stocks, for example, only to lose 38% of your investment over the next several years as happened in 2000-02. You want to avoid buying broadly diversified but nevertheless speculative froth!
One crude but certainly helpful way of judging the "Froth Factor" in the stock market is to compare stock pricing with underlying earnings. As a general rule of thumb, check out the prevailing Price Earnings Ratio of any stock market index before investing in it. The historic average P/E Ratio for U.S. stocks has been 14.6 [and that average includes long stretches of higher-than-average pricing]. When the P/E Ratio of a particular stock index is less than 14, it can be an excellent time to buy an index fund. When the P/E Ratio for a stock market is over 25, however, it’s time to get out of index investments.
Those guidelines are crude, but they can save your skin.
At the close of 2005, the P/E Ratio for the S&P 500 Index was 18.70 — a bit more than the historic 14.6 average. The S&P 500 index gave a full-year return of 5.9% last year. Despite what Messrs. Bugle and Swensen might tell you, the index’s higher-than-average P/E Ratio suggests that the stock market is still correcting.
In my view, this may not be a particularly good time to buy Vanguard’s VFINX [Vanguard’s S&P 500 Index Fund] or Fidelity’s FSMKX [the Spartan 500] unless you are buying and holding for at least 10 years. If you already own these funds and have a long time horizon, continue holding your index positions but do not expect high returns.
If you are investing with a 10-year or longer time horizon, then — yes — consider index funds. They generally trounce “actively managed” funds over long periods of time. But consider index funds if and only if the market is not overheated as crudely indicated by the P/E Ratio. You can check the prevailing P/E Ratio on-line. When there are signs of speculative churn-up, steer clear of index funds.
The information and views contained in this column do not represent a recommendation or solicitation to buy or sell any particular security or fund.
At the time of publication, the author may or may not have held any of the investments cited. His holdings may change from time to time. The opinions and recommendations expressed in these articles may likewise change from time to time without prior notice. Hence, readers are urged to conduct their own, independent research and consult their personal investment counselors before making any investment decisions.
Past results are not a guarantee of future outcomes. Investments of any kind can result in losses. When considering any investment, you should independently judge the content, management, fees, tax implications, historic performance, and risk factors of the investment and, in particular, read its prospectus and/or other offering materials.
The communications, comments, and opinions contained herein are intended solely for informational purposes. Mr. Schlagheck and this blog are not responsible for the accuracy, timeliness, or soundness of the information provided. All of the above commentary comes without warranty or guarantee of any kind. Neither Mr. Schlagheck, this blog, nor any other party can be held responsible for the validity, accuracy, or efficacy of these views or for the investment performance resulting therefrom.