Let’s face it. Investing our assets wisely can be complicated and confusing. With over 8,000 mutual funds to choose from, investors can get overwhelmed in a hurry. With all of the information overload out there, it is only natural that investors would want to flock to, what seems to be, a simple solution to our investing problems. “What if I could just buy three cheap mutual funds and be done forever?” One fund would capture the return of the total US stock market. Another would diversify us in international markets and the third fund would give us the entire bond market.
This is what many are advocating as a solution to the complexities of the modern investing world, but are there hidden traps to this seemingly ideal investment solution?
To understand what those traps are, an investor has to look at how these funds are put together and understand just a little about the investment research over the past 60+ years.
Total market index funds are typically “cap-weighted”. In English, that means that most of your money, when invested, goes into the largest companies based on market capitalization. So if I buy a mutual fund investing in the entire US stock market I might own over 3,000 stocks, but most of the money I invested goes to buying companies like Apple, Exxon, GE, Chevron, IBM and other massive US firms.
That may sound good to some investors. “Great, I own the most successful US companies. Now I can sleep easily.” Here’s the problem. Concentrating too much money in ANY one area of the market can lead to less than desirable results over long periods of time. Case in point: From 1966 through 1982, the S&P 500 (another popular cap-weighted index) had an annualized return of 0% per year when inflation is considered. From 2000 through 2012, the index lost .7% per year to inflation. Those are long stretches of time to go without returns, especially if you depend on your investments for income.
What is important to understand is that different areas of the market, which are not well represented by these funds, did quite well during these periods in history. Smaller companies, which only make up a tiny fraction of the holdings of total market funds, can be the real game saver when large stocks go through their periodic seasons of draught. We also need to recognize, as investors, that the biggest and most important companies of today will likely become the “has-beens” of tomorrow due to changes in technology and competition.
Another issue that becomes problematic is what might happen if we go through a period of interest rate increases? For thirty plus years, long term interest rates have been trending down. At some point this trend will come to an end and reverse. The outcome can be market declines and a drop in longer-term bond prices.
One of the redeeming features of total stock market funds is that they tend to stay away from trying to pick stocks and timing the market. Studies often reveal that such strategies tend to be counterproductive. However, buying these funds by themselves rarely results in the level of diversification that an investor should really strive to attain in order to reduce risk in their investments. Owning more funds that give investors exposure to broad areas of the market like small companies, value asset classes and better international representation is often the ticket to greater success in investing.
