Index Funds Work Better Together

Posted on October 17, 2014 at 11:25 AM PST by

“Buy an index fund, and then go to sleep for 50 years.” Sound advice in many ways. But is it the best plan to buy just a U.S. broad stock fund? What about bonds or emerging markets?

Owning the S&P 500 and only that index is indeed a powerful way to invest. Over the 20 years from 1994 through 2013 the broad stock market returned an annualized 9.2%.

At that rate, your money doubled every 7.8 years. An investment of $10,000 rose to a value of $62,525 over two decades.

index funds

What could be better than that? Well, real estate investment trusts (REITs) returned 10.3%, for starters. Foreign stocks returned 6.1% and bonds 5.7%. Gold, which has had a hard time lately, returned 5.7%.

You might be tempted to say, well, let’s put it all into REITs and forget about it. But there is a better way. Own it all in a portfolio, leaning most heavily on stocks when you’re young and then on bonds and other income vehicles as you age.

The reason you don’t load it all into real estate trusts (or gold for that matter) is volatility. The more volatile an asset class, the more likely you are to panic and try to jump in and out.

Stocks also rise and fall in value over the years and can go stagnant from time to time. Nevertheless, most pay a dividend and, over the long haul, stocks do produce a winning return, especially with those dividends reinvested.

Rather, it pays to own a diversified portfolio. In this sense, diversification has two sides. You own a lot of companies through index funds (diversifying risk) and you own a variety of asset classes, rather than just one or two (diversifying to reduce volatility).

Say stocks take off. Happy times, right? But you might eventually get the urge to begin to sell.

Here’s the problem: You never know if selling (or buying) is the right move at any given moment in time. You might buy a big position in stocks and watch it rise the next day or fall dramatically.

Powerful investing

In 10 years’ time it won’t matter. Stocks have returned about 6.6% over a century or so, and they are likely to continue to do so into the future.

You can add to those gains by owning smaller slices of more or less volatile companion asset classes, such as real estate, precious metals and bonds. As these asset classes move, they are likely to move counter to each other and to stocks.

Rebalancing allows you to sell off gainers in order to buy the short-term losers, over and over. As long as you keep costs under control, just rebalancing can add 1.5% to your return over the years.

Rebalancing in a disciplined way, staying invested and compounding is all you need to build up powerful retirement. Doing so at the lowest possible cost is just a side benefit of owning index funds to achieve your goals.