gaoyex uketap…

Phenomenal article. I see you are in the same position as I. Seeing as I can’t ‘properly’ diversify with individual funds in the way that I would like to, I am in the process of moving towards an index fund or two as my core investment, with individual stocks playing a supporting role.

I think you are on the right track, specifically in regards to low-cost investing. As you stated, an overwhelming majority of actively managed funds do not outperform their respective index over the long haul.

“Over the 35-year period from 1971 to 2004, the average annual return on all actively managed equity mutual funds trailed the S&P 500 Index by 87 basis points a year, and the broader-based Wilshire 5000 Index by 105 basis points a year. Over long periods, this difference in return amounted to substantial differences in wealth.”

And, even when a fund does outperform their index, the substantial increase in fees usually negates any advantage!

Anyways, keep up the great work. Sounds like we are in the same boat!

Two things that specifically struck me:

1) While bonds are mostly sold at 2-5% rates, it’s exciting to see that a fund that trades bonds can make up to 8-10% per year.

2) I like how you always kept fees in mind when deciding which fund to go with (a major point of your post).

One more thought… It is “common” wisdom that us youngens can afford a little more risk early on, and you seem to be avoiding risk more than is often suggested. Being risky goes against the fact that lower consistent returns can often be better than higher but more deviating returns. Consider:

Fund A 5% 5% 5% 5% avg=5%
Fund B -10% -5% 10% 25% avg=6%

$100 invested in Fund A would have a value of $121.55.
$100 invested in Fund B would have a value of $117.56 even though the average return is higher.

I still have to fully process the implications of this against the common wisdom that I should be gambling more in my early life.

The basic foundation for a bond / stock mix is that when stocks go bad, bonds are good and visa versa. By owning bonds, especially when you think there is going to be a bull market as you stated, you protect yourself from negative or stagnant earnings from stocks. Mind you, it’s not about asset protection, it’s about creating solid, consistent returns, until i learn enough to create better returns with stocks.

Instead of the bond index fund, I’ve ended up chosing 2 bond funds: an emerging market fund that over the last 10 years has earned over 10% annually, and a long-term investment-grade fund which has earned over 8% annually. Long term bond funds with longer durations are more volatile in light of interest rate pressure, and if the market turns south, prices will skyrocket, leaving me with more valuable assets. Additionally, foreign government bonds do not follow US market trends additionally counteracting a bear market.

Now as you mentioned, my primary investment is going to be in an S&P Index fund. Do I think that’s the ideal situation? No, but if I own a couple focus funds and the market turns, I could have trouble. Plus, if the market turns south, I’ll be able to take my index fund and dollar-cost average my way to pretty returns when the market rebounds. On the other hand, if the market continues it’s climb, then I’ll be glad I got in when I had the chance.

When I’m picking a mutual fund, I not only want strong fundamentals, but returns that consistently outperform its benchmark index over 10 years. Remember, the vast majority of mutual funds can’t beat an index over the long term, for many reasons – be it management, or carelessness, or being a victim of its own sucess.

While looking for stock funds to complement the index fund, I was very hot on the Berwyn Fund (BERWX). Having strong fundamentals and stellar returns for the last 5 years (over 20% avg), over 10 years it had just barely beat out the Russell 2000, which incidently had just barely eeked out the same return as the S&P 500.

I ended up not going with the fund, and instead going with the S&P Index fund because since expenses were about 1% lower, I actually would be earning more money than with the Berwyn fund. Despite it’s high ratings, and stellar fundamental, at almost any point in the last 10 year period except for the last year, shared in the index fund would have been worth more money.

Here’s the bottom line. I believe that individual stock investing is the way to go… eventually. However, in my opinion, investing totally or primarily in stocks without fully understanding fundemental and technical analysis, and also not having at least 10 stocks that meet my valuation criteria is really asking for trouble, and frankly, speculation.

Honestly, let’s call a spade a spade here. If you don’t fully understand a company’s business model, value it at a price that is attractive with a good margin of safety, and haven’t determined that fundemantally it is a good company, then you are gambling — plain and simple. Now you go out and prove to me that you’ve built a portfolio with a half dozen or so of those companies, and not only will I stick my foot in my mouth, I will stick my money in your brokerage account.

Warren Buffett and Ben Graham both agree that dollar-cost averaging and index investing in both stocks and bonds is the safest way to get started. We have a LOT to worry about before we get setup with stocks. We have brokerage accounts to worry about setting up, books to read, companies to research… why lose sleep over investments we are not 100% confident about?

I’ll leave you with this thought: true investing should be boring.

1) Why any bonds at all? I’m curious about the details behind your 25% number. Is that what Graham recommends as a minimum? Even for twenty-somethings?

Personally, unless I feel the market is going to do particularly badly, I’m trying to avoid bonds until I’m at least 30. I just don’t have that much capital to preserve. And if I feel the market is going to do poorly…

2) I would stay away from index funds during bear markets. There are a lot of indicators pointing towards a bear market right now. In these markets, index funds are going to (by definition) lose money on average. The way to make money during a bear market is to pick specific stocks and sectors which are going to grow despite the fact that the rest of the market is gloom. Think any stock we’ve recommended here Think “Internet Stocks”. Think “Alternative Energy Stocks”.

Now, moving away from index funds would go against your diversification goals. I would maybe give yourself some time to fully diversify. Pick a decent growth/emerging-markets fund and a couple stocks you think solid (read: not speculative) enough to ensure you don’t lose your shirt. Every year, add to your positions and pick up one or two more stocks. In five years, you’ll have a decently diversified portfolio.

p.s. I’ve been talking a bit about the bear market threat. And I really need to post my real intuition about how the market is going to do over the next few years. It’s not going to be all bad. In any case, investing in specific growth stocks and sectors doesn’t stop working during a bull market. It just may end up being a bit of wasted effort when similar results could have been obtained by simply buying everything (index).