The Confident Investor

Jack Bogle passed away this week. Jack was the founder of Vanguard. Fortune magazine named Bogle as “one of the four investment giants of the twentieth century.”

Jack has received a lot of press since his death commending him for “creating” the index fund. This was a great advantage for the individual investor as it allowed the individual to have a wide exposure to the market with a fairly low cost. I regularly advise that 20-40% of your portfolio should be in index funds (depending on age).

Most people recognize that Charles Dow published the first workable index in his newsletter Customer’s Afternoon Letter and then later in the Wall Street Journal. His average was eventually called the Dow Jones Industrial Average (often shortened to Dow, Dow Average or DJIA) and is the most widely quoted number regarding the movement of the US stock market.

A stock market index is a basket of securities designed to track market changes. The most widely followed US stock market indexes, along with the DJIA, are the S&P 500, and the Nasdaq Composite. Important international stock market indexes are the Nikkei 225 (Japan), FTSE 100 (UK) and Hang Seng (Hong Kong).

Each stock market index has its own way to combine the changes in index components. The Dow Jones, for example, is a price-weighted stock market index where an increase of $1 in the stock of a $300B company produces the same change as an increase of $1 in the stock of a $30M company stock. Most stock market indexes use capitalization-weighted adjustments to account for the differences in company size.

An index fund is an investment framework that tries to mimic the movements of a particular index. The fund is usually structured as a mutual fund or an exchange-traded fund (ETF). An index fund is created to hold all of the securities in the index or a representative set designed to mimic the entire index. Many index funds rely on computer models with little human input in the decision as to which securities to purchase. This is a form of passive management. The absence of active management usually provides the benefit of lower fees and lower taxes in taxable accounts.

EXAMPLE: An S&P 500 Index Fund takes all the stocks in the S&P 500 and buys enough shares in each company to represent the dollar value that each company represents as a percentage of that market. So, if the Acme Company represented 2% of the combined value of all the S&P 500 companies, then an S&P 500 Index Fund would have 2% of its dollar value in Acme stock.

Index funds frequently outperform and have lower fees than managed funds. Index funds are often a better investment alternative. I encourage you not to have too much of your portfolio in managed funds but instead focus on index funds.

It is easy to track the results of an index. If the S&P 500 went up 1.5% over a one week period, your S&P 500 Index Fund did too. The same would be true if it went down. Index funds can be part of a balanced stress-free portfolio. You can use them to buy a comprehensive “market” position.

The problem with index funds is that they only perform as well as the market. In any trading day, there are stocks that go up or down. This is the same over the period of a week, month, several months or even years. While an index fund is easy, it is not necessarily advantageous for your entire portfolio. You are, by definition, only doing “average” with your hard-earned money.

Also, the increase over the long term in any given index is almost always reduced by inflation. If the market increases 6% or 7% in a year, you can almost bet that inflation, measured by the consumer price index (CPI), rose two or three percentage points. You need to stay ahead of the CPI in order to be able to buy more things for you and your family.

Every year, Standard & Poor’s conducts a study of actively managed mutual funds. Invariably they find that benchmark indices outperformed a majority of actively managed fixed-income funds in all categories over a five-year horizon.

One index fund is probably too risky. If you are still working then take 20% of your investment fund and divide into at least four categories:

• international funds
• bonds funds
• small-cap or mid-cap funds
• large-cap funds

I suggest that you balance your fund investments equally every year. This means that you would have 5% of your portfolio in each fund category. You may have to annually add money from the individual stock 80% of your portfolio to maintain at least 20% index fund exposure.

It really doesn’t matter which company manages the index fund you choose. There is some variation in international funds since they can track many different markets so you may need to study a bit for that component. There is little true variation in bonds funds so just find one that tracks the Barclays Capital Aggregate Bond Index. For the stock index funds, they should track one of the S&P indexes or one of the Russell indexes.

If you are over 65 then you may want to start dropping down to 60% of your portfolio being in individual stocks and 40% index funds. You definitely want to consider this if you are over 75 years of age. However, if you are under 65 then you probably should have a portfolio of stocks that is approximately 80% of your portfolio. At 65 you may think you need to be more cautious, but there is a high probability that a 65-year-old person is going to live to be 90. If you have reached the glorious age of 75 then you are even more likely to live to 90. With 25-45 more years of spending to do, you really need your money to continue to grow even if you are retired. As you approach 80 or 90 years, you may want to have a more even mix of stocks, bonds, and money-market cash. To understand this better, check out my whitepaper, Retire In Luxury.

Divide 80% of your portfolio into equal allotments that are larger than $5,000 per allotment. You should have at least 10 allotments in a balanced portfolio. You could have 20 or 30 allotments depending on the size of your portfolio. If you do not have $50,000 to divide 10 ways then divide your existing portfolio into $5,000 increments. You will find that you are much more efficient and profitable if you invest $5,000 or more using GOPM. If you have fewer than 10 allotments, be very diligent about getting a good mix of industries so that you are not overly hurt by any one trend.

Regardless of the number of allotments that you choose, you need to choose twice that number in stocks that you are tracking. So if you have 10 allotments, you should track 20 stocks. This allows you to always have a stock that is rising to invest your money. Invariably, some of your tracked stocks will be going sideways or down but by tracking double the number you need, you are likely to have 10 that have upward momentum.

You should plan on investing in 10 to 30 companies at a time using the tools that I show in The Confident Investor. Grow your investment in any individual stock until you have doubled your money using GOPM (Grow on Other People’s Money).

When you have doubled your money in half of your companies, you may want to consider changing your allocation size to a larger allocation. This will allow you to continue to grow your investment in those great companies.

It is also possible to stop investing in any given company at half of an allotment or twice allotment depending on how you feel about that company. You should also factor the number of companies in the same industry you already having a portfolio. For instance, if you have 2 companies in nearly every industry except you only have one mining company, feel free to allow that mining company to grow to a double allotment. Similarly, if you have 3 software companies in your portfolio then you may want to limit one or all of them to a half allotment so that your portfolio is not overweight in that category.

Jack Bogle made life better for individual investors and I advise you to take advantage of his leadership and put index funds into your portfolio.