A stock market survival course: Part 4
Thursday, December 13, 2018
This is the fourth of a five-article survival course designed to give you essential information you need to succeed as an investor in the stock market. Everything stated in these articles is backed by the research of well-known economists and published in leading journals of economics and finance. Each article can be read in 10 to 15 minutes.
The root of the problem lies in the attempt to beat the market through trading. Even the 5 percent of active mutual fund managers who beat the market in a given year can’t repeat their performance. A better approach, which I began outlining in the third article in the series, is to give up the attempt to beat the market. Instead, try to come as close to matching market performance as you can by:
- buying and holding, which reduces capital gain taxes and transaction costs; and
- lowering management fees by buying mutual funds and ETFs from the lowest cost providers, such as Charles Schwab, Vanguard and Fidelity.
This article discusses easy ways of diversifying your investments to lower risk and improve returns.
Lowering Risk by Diversifying
The key to success in the stock market — probably in every financial market — is to lower risk as much as possible. One way of doing this is by diversifying your equity investments.
In essence, diversification is pretty simple. You invest in many different asset classes and within each asset class you spread your investments among many different issuers.
An easy, low-cost way to achieve diversification is to buy broad market index funds through a low-fee management company. The broadest index funds, called total market index funds, aren’t the only recommended index funds, but when you’re building a portfolio, they’re a good place to start.
Vanguard’s Total Market ETF (VTI.IV) has an expense ratio of 0.04 percent, which means the administration fee for $100,000 invested in the ETF is only $40. (Incidentally, when you begin looking for promising highly-diversified funds you’ll notice that ETF fees are almost always lower than fees for mutual fund with similar holdings).
Vanguard was the first company to introduce low-fee index funds. Recently, Charles Schwab has responded by creating a number of even lower-cost funds. Schwab’s Total Stock Market Index Fund (SWTSX), with holdings nearly identical to Vanguard’s closed VTSMX fund, has an expense ratio of only 0.03 percent, which translates to an annual management cost of $30 on a $100,000 investment. Fidelity also offers a Total Market Index Fund (FSKAX), with an even lower expense ratio of 0.015 percent.
Management fees for all three of these companies are extraordinarily low, about as close to free as you can get. Because Schwab’s entry into the low-cost index fund market puts pressure on other providers, it seems likely that in coming months other fund management companies will offer similarly low-fee funds.
Another benefit of investing in index funds rather than in active funds where the investment manager attempts to pick stocks to beat the market average is that index funds lower capital gains taxes.
Once the manager of an index fund creates a portfolio, except for periodic and comparatively minor adjustments to account for changes in the ratio of a given stock’s capital to the capitalization of the total market, the index fund manager has no reason to sell stocks that make up the index. Shareholders don’t have to pay capital gains on the profits of shares in the fund until they’re sold.
The active fund manager, on the other hand, regularly sells equities in order to buy other equities the manager believes will outperform the market. Whenever that happens, the fund’s shareholders have to pay any capital gains taxes due on profits from that sale. Buy and hold index funds have an inherent tax advantage over active funds.
One question you may have is how much risk reduction you can achieve through diversification. Using data from Morningstar, Inc., Schwab’s Center for Financial Research has quantified the risk reduction. In a year when the overall market gains 6 percent, a fund with only 5 stocks has a 40.1 percent chance of losing money. A fund with 20 stocks has about a 25 percent chance, while a fund with 40 stocks has only a12.9 percent chance of losing money. Clearly, the benefits of diversification are substantial.
Diversified investing lowers risk and substantially improves investment returns. Index funds that invest passively in large market segments or the total market consistently outperform funds with active managers who seek to outperform the market. Index funds also provide an inherent capital gains tax advantage over active funds.
In the forthcoming final article in this series, I’ll examine the relationship between risk and reward and the conventional wisdom that higher returns require higher risk. Finally, I’ll suggest a portfolio management approach that takes into account the insights shared in these articles, one that avoids investor-sentiment mistakes by using the stock market cycle as a general guide to investment practices that maximize returns.
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