Hi guys, I posted this on the Motley Fool discussion boards, but I’m interested in what you guys think as well - my basic question is index funds vs. individual stocks for your retirement account. I honestly haven’t given it all that much thought, but I’m realizing that it’s a fairly important decision…anyways, here’s the post… I am a long-time reader of the fool boards, and a recent college graduate. I very much enjoy following the stock market, and am actually working in finance on wall street. For the first time in my life, I am making enough money that I am able to start saving substantially for retirement. I am lucky enough to have no debt, no student loans, and no credit card balance. I also have enough liquid cash to cover my expenses for a while if something horrible happens, plus I have a supportive family that would take me in. I am planning on maxing out my 401K but need some advice regarding how to invest the other money that I will be putting towards retirement. I think I have basically two options. Either invest in no-load index funds like the s & p 500, or try to beat the market by selecting individual stocks to hold for the long term. Basically, I’m confused by the contrasting information that there seems to be out there. One the one hand, the index fund folks like to espouse the view that the majority of money managers and individual investors do not beat the market over the long term. Although I do think that I am probably an above-average investor, I don’t think it’s smart to assume that I would do better than average, esspecially since money managers spend their entire lives analyzing stocks (though I know they have some liquidity constraints that I do not). It usually gets people in trouble when they assume they are smarter than everyone else. On the other hand, the other school of thought for retirement investing seems to be “You’re young, invest aggressively, you can deal with the risk and volatility since you won’t need this money for 10+ years. Your best bet is to build a small portfolio of high-quality growth stocks”. To me, this seems paradoxical if you assume that the index-fund stats are true. If most people cannot beat the market, what is the reasoning behind buying individual stocks, even if the outlook is long-term? My goal is to get the best return possible - if, on average, most people underperform the market when they do this, why would it matter what my risk appetite is? The assumption seems to be that more risk=greater return, but the index fund stats would suggest that this is false, right? Out of necessity, my 401k money has to go into funds, so at most about half of my savings will be invested at my discretion. The only decision I have to make is whether to invest ALL of my money in index funds or whether to build a portfolio with half of it. I guess the reason that I ask this question is because I’m thinking about using one of the Fool’s advisory services - either Stock Advisor or Hidden Gems. Although I’m disheartened at the level and tone of advertising that these services have developed, I’ve been very impressed by the quality of these products (I did the free trials a while back), and if you look at their performance (although admittedly fairly short-term), they’ve outperformed the market by a good deal. If I do decide to buy individual stocks it will probably be under the guidance of one of these services…so I guess this just restates my original question - is it better to try to beat the market in this way, or should I buy straight index funds? Thanks very much for any advice, opinions, or even direction for good sources of advice on this issue. Luke
Asset allocation accounts for between 80 and 102% of return. Before focusing on suballocation (i.e., which USA large-cap equities to invest in) you should first determine an appropriate asset allocation. This should take into account your human capital (typically treated like a domestic bond), excess real estate (i.e. if you will downsize your residence upon retirement), and the wealth of options beyond USA equities.
My vote is index funds/funds that mimic the total stock market. Plus, I’d diversify internationally. I also agree with DarienHacker–asset allocation is key.
Ok, well I guess the underlying assumption is that US equities are the best place to invest money over the long-term. I think it’s clear that some international markets will outperform the US, but given the difficulty and uncertainty in predicting which ones will do this, I’m going to keep the majority of my money inside the US, with some foreign exposure via mutual funds. I have no real estate/other investments to speak of. I’m not really even sure what the sentence “Asset allocation accounts for between 80 and 102% of return” means - how could it possibly account for more than 100% of return? Anyways, leaving aside that argument, the question still stands, for assets invested in US stocks…what is the best strategy for them?
My Schweser notes says it is 80-95%. Not sure where that 102% comes from. 
102% is from a vanguard study; the remainder (-2%) is provided by the fund manager. Given that many of them consistently underperform their benchmarks, it’s easy to believe (even if the source is biased away from active management). I’m sure many funds’ returns receive 120% or more of their return from asset allocation. Luke, you need to ready chapter 1 of any investment management book you’ll pick up: Diversification. (And there won’t be a chapter 2.) Or pay $10 for last year’s L3 books from anyone on ebay. Also pick up a personal financial planning text. If you’re not taking advantage of personal residence tax breaks your cost of funding is probably unnecessarily high. Picking individual equities at this point is putting the cart before the horse.
The “You’re young so you can tolerate volatility” is more of a statement about allowing yourself to be exposed to more volatile asset classes, and not so much a statement about how wise it is to choose individual stocks. So you should still be in some diversified fund even if you are young, unless you plan to be an active portfolio manager for your retirement account. In traditional investing, bonds and bond funds have two purposes… one is to provide fairly reliable cash flows in the form of coupons and principal repayments that you can use for income and expenses that you know you are going to have. This is useful in retirement, but not so much when you are young and saving for retirement. You preserve your capital more effectively by using bonds, but this extra security costs you in the form of a lower total return. So when you don’t need this security for a long time, it’s better to go for the higher return in stocks. That’s what the “You’re young,” comment is about. The other use of bond funds is for diversification. If you balance it correctly, you can actually obtain more or less the same expected return as you do from a stock portfolio, but have less volatility in your stock-bond portfolio. This is a sensible thing to do, even if you are young, because taking on un-necessary risk is pointless at any age. You can’t get exactly the same expected return in the stocks+bonds fund without leveraging a little (which I don’t think is allowed in 401ks), but even if you don’t leverage to get back up to the stock-only fund’s expected returns, the reduced chance of a large drawdown tends to outweigh the sacrifice of a little expected return over the long run. To see this in action by looking at the extreme case: “If you invest everything in one company and it goes bankrupt and your capital goes to zero, then the fact that equities reutrn a lot over the long run doesn’t help you at all, because a 50% return on 0 is still 0.” So the way the probabilities multiply out, it turns out that the small return sacrifice is usually worth the reduction in volatility, even if you are young. As for managing individual stocks in your retirement account, I think you can do some stock managing in an IRA, and so you could put your 401k in an index and then do small deviations from that index by some stock picking - essentially an “enhanced index fund strategy.” I wouldn’t necessarily recommend this, because to do it well will take a lot of work that will probably pay you better by doing it with someone else’s money, but it’s technically possible. Finally, on the growth fund strategy. My understanding is that for the past 20 years, value stocks have generally outperformed growth stocks, and although there is no guarantee that this will continue (in fact, most estimates are that growth is likely to do well in the next 12-18 months, the idea that you should be in a growth fund is not so obvious. Remember that a “growth fund” doesn’t necessarily mean that they’re trying harder to grow your money, it’s more about the kinds of bets they are going to be making (i.e. on growth companies) to make your money grow.
As prior posters have noted, diversification and asset allocation should be your focus, not stock-picking. A couple of reasons not to stock pick with your retirement account. First, just because you have or are pursuing the CFA designation doesn’t mean you know jack about researching and selecting stocks. Even the experts underperform the indices much of the time. That is why diversification is critical. Not just 10 stocks vs. 20, but hundreds… And I assume you don’t want to make investing your retirement money a full-time job, because that’s what it would have to be if you were investing in many stocks and actually following and researching them appropriately. That’s what index funds provide to you. Additionally, the transaction costs of investing in many different stocks (to attempt diversification) would kill your return. I know you hear from those hot shots who brag about their returns on individual stocks. We all know them. They’re not telling you how they lost their shirts on many other stocks (and believe me, they’ve had losses). Additionally, if you feel compelled to pick some stocks, take a small portion of your IRA or brokerage account, do some in-depth research on a few stocks and buy them if you so desire. But don’t invest the majority of your retirement accounts this way.
I don’t know if my question is being misunderstood or what, but these answers are not at all what I expected. I’m under the impression that many/most of you have the ultimate goal of becoming a PM or similar role…if you guys think that an index or similar strategy is the best bet for retirement money, what does this say about the value that you add to your clients? BTW, the obsession with diversification seems to me to be way overdone for someone in his/her 20s. I have no need to diversify into bonds if I have faith that over the next 20 years stocks will outperform, which historically has been the case. Even if a stock fund/index will only outperform by 1% (and I think it will be significantly more than that), that 1% adds up to a ton of money with the effect of compounding over 20-30 years. Maybe a better way to ask my question is: how do you invest your retirement money, and why?
I’m in fixed income, so am not a stock guru, nor do I have the time to spend to read financial statements, listen to conference calls, etc. for tens to hundreds of holdings. Does this mean that I don’t add value to fixed income investors? I sure hope not. I have very little in bonds (< 10%), but the majority in various equity funds. Twenty-somethings who can consistently beat the market are few and far between. Twenty-somethings who think they’re expert stock-pickers abound. Also, if you pick 10 dud stocks, it doesn’t really matter whether the overall stock market increases over time. You’re toast.
You know, I sometimes point out to near retirement or just retired people that it’s not necessarily a bad idea to have a small proportion of their portfolio (maybe 5% or 10%) in agressive stocks (as long as their basic cash flow needs are covered by other assets). Their reaction: “Stocks are way too risky, how can you possibly recommend this.” Now I see the other side: I point out to a just-starting out person that it’s not necessarily a bad idea to have a small proportion of their portfolio (maybe 5 or 10%) in bonds. Their reaction: “Bonds are way too conservative, how can you possibly recommend this.” How can I recommend this? The secret is *rebalancing* (which a lot of people don’t do in their retirement funds). If you rebalance annually or so (probably not more often than quarterly), then what you find is that when you are hit with the downside of stock volatility, you tend to have a higher total capital available to apply to equities than you would otherwise have in your next holding period. This means, effectively, that you can buy more shares when stocks are cheaper and improves your dollar cost averaging. Now it is also true that you will not have quite as much gain on the upside of the equity market, but that is not as big a problem as you might think, and that is because a 50% gain on the upside does not help you as much as a 50% loss on the downside hurts you. The rebalancing system also helps you by reducing the quantity of stock shares you buy when they are expensive, while increasing the quantity you buy when they are cheap.
Luke, I am 23 and in a similar position you are in. I did a bunch of questioning, researching, etc before I opened my retirement and taxable accounts. Here is the advice I help onto. Being you probably don’t have a ton of money to invest, a low expense ratio index fund (Vanguard) will do everything an individually picked diversified stock portfolio will do for much less. When you build a bundle ($25,000+), then you could venture into other strategies. It is VERY difficult to beat the indexes. I work in a asset management firm and I see many PM’s do not beat the indexes consistently when I do the monthly reporting. On top of all that clients paid their advisors for all the advice they received only to fall short of what an index fund would have done. My personal portfolio consists primarily of LCB, MCB, and SCB ETF’s. I do have a few outlying individual stocks, sector ETF’s that I have picked. If you want sustained appreciation, indexing is the way to do it. I do see value though to researching and picking a security that you believe to be undervalued. Much like gambling, the odds are against you, however many of us feel like we are above the statistics.
While the PM’s don’t often beat their BM’s it should be said that they are under a whole lot of restricitons. I know this first hand because my job is monitoring the restrictions and telling the PM’s to correct their positions when they go out of line with the guidlines. The reason I am saying this is that i am also a fairly young guy and hence, invest almost entirely in equities. I do cherry pick some stocks though. I don’t think it is that unreasonable to better the indices slightly without too much effort since you are not personally constrained by the same guidlines that PM’s are. I think the tough part is having the discipline to not overweight in hot stocks, which then drop like stones after the hype wears off. I have seen a lot of guys lose big doing this and it is tough being that disciplined. All this being said I have more than half my money in various equity funds… I use funds as opposed to ETF’s because I can buy my companies funds with no loads and have access to a wide rage of internationally diverse funds.