Standard advice from many experts today is that a person should invest in a broad index fund that tracks the U.S. stock market as his/her main investment strategy to gaining wealth over the long run. A commonly cited broad index fund that experts suggest is the Vanguard S&P 500 Exchange Traded Fund. This fund tracks the performance of the S&P 500 index, a widely recognized benchmark of the U.S. stock market that consists of the 500 largest companies listed on the U.S. stock exchanges. It has an annual expense ratio of 0.03% and a dividend yield of 1.84%. This means if you have $100,000 in this fund you will pay a super low fee of $30 per year to the the people that manage the fund and you would receive $1,840 per year in dividends. I will use this index fund as my example in this post.
Warren Buffett advocates buying a “broad index” for most investors because he thinks most investors just are not very good at picking individual stocks. He has said that over the long-run investors will do better with a broad index fund because of its low fees/expenses.
Mr. Money Mustache, the self-described thirty-something retiree who lives the “Badass life of leisure,” says the “best way to make money in the market is to simply buy an index fund.” In fact, he states “you only need one thing to retire early : a generous bucket load of low-fee index funds [and] it can even be a single index fund…”
The reasons people like Mr. Buffett and Mr. Mustache advocate a broad index fund as your primary investment fund are two-fold: 1) an index fund diversifies your investment in the stock market because it invests your money across many different companies that are part of the broader economy and 2) the management fees for most (but not all) index funds are small. I agree with these reasons for choosing an index fund as a good way to invest in the stock market for most people. There are plenty of studies which show that most investors do not know how to pick stocks and most professional fund managers cannot consistently beat the performance of a broad index fund (and therefore paying them a big fee does not make sense).
Let’s take the Vanguard index fund. It has 500 large companies as part of its index fund and its annual management fee is much less than 1%. Diversification – yes; low management fees – yes. It has shown an average annual return of just under 12% over the last five years.
Good returns, diversification, and low costs. No need to invest in anything else, right?
My issue with using an index fund like the Vanguard index fund as your main investment is that it only provides part of the solution to a solid investing strategy for an investor. It is not the end of the story and too many people talking about financial independence promote it as such. Here is why it is not that easy and why you need to do more as an investor.
An Index Fund Only Provides Limited Diversification
And index fund provides diversification to offset company-specific, and sometimes industry-specific, risks. When your index fund owns 500 companies, a negative surprise for any specific company or a certain industry is not going to drop the value of your index fund by very much. If a single company in your index fund’s stock price drops by 20% because of bad earnings or some other negative event, it will probably be less than 1% of your total index fund therefore the 20% drop in the individual stock price is less than a 0.2% drop in price for the index fund. If you believe in the U.S. economy as a whole but don’t want to be exposed to significant individual company risk then the Vanguard fund or something similar is a good way to go for your exposure to the stock market.
However, when the stock market crashes most stocks are highly correlated to each other. When there is a significant market correction your index fund is going to get hit just like most individual stocks. The diversification that the Vanguard index fund provides to reduce individual company risk does not help you with a broad market sell-off. Your diversification within one asset class – stocks – really does nothing for you in this situation.
The key to diversification is investing in more assets than just the stock market. The less correlated the assets, the more likely your portfolio will withstand a significant decline from any one asset class. Ray Dalio, the founder of Bridgewater Associates (a highly successful hedge fund) calls diversification among different asset classes the “Holy Grail of Investing.” You do not achieve this type of diversification from a broad stock market index fund. Unfortunately, individual stocks that are added together are still highly correlated in their performance when there is a stock market correction.
Take for example the market correction that took place in the fourth quarter of 2018. During that period of time the Vanguard index fund we have discussed dropped by over 20%. Diversification with and index fund did not help when the stock market had a big sell-off.
Investors need to establish diversification among different asset classes that are less correlated. For those that do not know, different asset classes include:
- Public Equity (e.g., Stocks)
- Real Estate, which can be further broken down
- Real Estate Equity
- Real Estate Debt
- Commodities, which can be broken down into gold and other commodities.
- Bonds, which can be further broken down into:
- Corporate Bonds
- Government Bonds
- Private equity (e.g., stocks not publicly traded)
- Other Real Assets (think of things like timber)
Granted, it takes a bit more knowledge and experience to appropriately diversify your investments across different asset classes. However, Mr. Dalio has outlined what he calls an “All-Weather Portfolio” so that the average investor can see how he generally uses different asset classes to diversify a portfolio across different asset types. In the All-Weather Portfolio, Mr. Dalio suggests the average investor hold about 30% of his/her investments in U.S. Stocks (e.g., the Vanguard index fund). He uses short and long-term U.S. Treasury Bonds, Gold and a broader set of commodities to round out his model All-Weather Portfolio. You can actually buy exchange traded funds for bonds, gold, etc. to give you exposure to those other asset classes and I will discuss some of these in a different post.
Mr. Dalio’s own research has found that investing in six uncorrelated assets (with the correct weighting) can reduce your risk/volatility by nearly 60% without significantly reducing your long-term returns.
If you check-out my quarterly financial updates over time you will see how I have tried to diversify my investment portfolio across different asset types to (1) reduce volatility and (2) generate cash flow. This brings me to my next reason why an index fund strategy alone is not enough for an investor that wants to maintain long-term financial independence.
The S&P 500 Index Fund Strategy Is Not a Good Cash Flow Strategy
Those who have read my strategy to maintain financial independence understand that I believe increasing cash flow generation is paramount to long-term financial independence and withstanding prolong downturns in asset values. Index funds that mirror the S&P 500 index do not generate significant cash flow. If you had $1 million invested in the Vanguard index fund you would generate about $18,400 per year in cash dividends. That’s not a lot of cash generation on your $1 million investment.
You can diversify your stock market investment through an index fund that focuses on dividend yields and therefore still get good returns, diversification within the stock market, low costs, and better cash flow. For example, the Vanguard High Dividend Yield Index Fund owns about 440 stocks, has an annual expense ratio of less than 1%, and has an annual dividend yield of 3.1%. It has shown an average annual return of just over 12% during the last five years.
Other asset classes can also generate greater cash flow. I generate an annual cash yield of approximately 4% from my portfolio that is diversified among multiple asset classes. The total return on my portfolio over the last few years has trailed the S&P 500 but it has shown much less volatility and still had solid returns. The important point here is that when we have the next recession or significant market correction my portfolio should see less volatility and in the meantime it should still generate a stable source of cash flow to cover my expenses.
A Few Simple Recommendations to Consider
- Even the least educated of investors should establish diversification among a few asset classes and hold an index fund for stocks and a separate index fund for bonds. Check-out the All-Weather Portfolio to understand how you can weight these positions.
- Consider an stock index fund that generates a higher dividend yield than the standard S&P 500 index funds. Dividend stocks have historically been strong performers and by holding a higher dividend yielding index you can generate better cash flow from your investments in the stock market. Check out the index funds with the ticker symbols VYM, DVY, SDY and HDV for some index funds with higher dividend yields than the S&P 500 funds. Note – you will be taking on greater risk if you start looking for index funds that generate high-single digit dividend yields. As a general rule of thumb you need to really understand the risks from owning a stock or fund that has dividend yields in excess of 7%.
- As you become more sophisticated with your investments, consider different asset classes to invest in to further reduce your risk. You may want to take this step after you have some money saved and some time to research different investments. I will highlight different types of investments for you to consider when you are ready – such as trust deed investing – and you can see how they are performing in my own investment portfolio.