In my book describing Strategic Stock Accumulation (SSA), I have a chapter devoted to exchange traded funds (ETFs), and more specifically, index funds. They are the only types of securities bought and sold in the SSA Strategy. I’d now like to review the reasons why this is so. The attraction of these securities revolve around risk (low) and cost (low). Many investors have been brought up on a diet consisting of the purchase of individual stocks almost exclusively. Many of these same inestors are convinced that this is the only way to go.

Some investors even believe that individual stock purchase is the only way to ” make a killing” in the stock market. Others are convinced that buying only five or six individual stocks in different industries, countries, or sizes is adequate diversification. And some are attracted (or addicted) to the excitement that the volatility of individual stocks offers. All of these reasons are invalid.

If an investor is focused on “making a killing” by picking the next Google or Microsoft in its infancy, good luck! Usually by the time a “Microsoft” is recognized for its profit potential, this potential is almost universally recognized. In other words, it’s future value is already “in the market”, making the stock already fairly valued or even overvalued. As far as five or six different stocks providing adequate diversification, and capital gains potential, the investor had better be prepared to make allowance for many hours of personal effective research followed by constant vigilance. Why? Because it is so easy to get blindsided.

Fraud charges brought against a company or some member(s) of top management, expropriation of assets or prosecution by a foreign country, and surprisingly, poor results are among the most common “surprises”. Finally, if an investor is attracted by the excitement of the stock market, he would be better off becoming a ‘day trader’ or going regularly to Vegas (both are equally profitable-not!)

I’m not really down on individual stocks, only when they are bought individually. There are too many negatives that are too difficult for most investors to overcome, not the least of which is, additionally, high costs, especially as compared to index funds (usually structured as ETFs). So, now is a good time to discuss what I believe is the indispensability of this type of indexed security.

ETFs are a type of mutual fund that, in most cases, are also classified as index funds. An ETF is an index fund that trades like a stock throughout the trading day. There are index funds that are not ETFs. They are set up and funded like ETFs, but are only bought and sold after the markets close for the trading day. Index funds are appropriately named because they are”indexed” to a particular benchmark index, such as the S&P 500 or the Dow Jones Industrial Average.

The  index funds attempting to mimic, as closely as possible, the results of those two benchmarks would typically hold dozens or more of different stocks within the fund. These index funds are indeed indispensable to the stock market investor intent on limiting individual stock risk and investment costs.

Why do I say index funds are the indispensable stock market vehicle? There are three primary reasons. One is the very important feature of diversification, which all index funds offer. The second is the potential for reducing investment costs to rock bottom. And the third reason is the almost impossibility of managed mutual funds to outperform the typical passive, non-managed index fund over a ten year or more period of time. Let’s examine these advantages in more detail.

There are two parts to diversification. One is the diversification necessary for the reduction of individual stock risk.. The specific type of risk I’m referring to here could typically relate to one or more of the three risks of being blindsided, as discussed above, by fraud, expropriation, and surprisingly poor financial results. The other type of diversification is commonly referred to as correlation (or negative correlation).

Negative “correlation” refers to the hedging involved in choosing stocks within any kind of mutual fund or grouping of stocks, as well as different funds within a portfolio, which react differently to the same market conditions. In other words,  when one stock or fund goes down as a result of some change in the market or economy, another one goes up, hopefully by the same amount in reaction to the same change. This negative correlation reduces risk in the portfolio.

These stocks and funds reacting in the opposite direction to the same factors would then be said to have a negative correlation. If two stocks or funds react exactly opposite to the same factors, they would then be said to have a negative one (-1) correlation. If two stocks or funds react exactly the same to market or economic factors, they would be said to have positive correlation of one (1). Most stocks and funds are not as extremely correlated either positive or negative, as these two examples. Two index funds within a portfolio may have a  correlation of .5, for example. In that case, one stock would be predicted to react 50% more or less than the other as a result of some change factor. Of course, this correlation, negative or positive, is just an estimate, and could be way off in the real world.

Regardless, we would like to have a combination of index funds in our portfolio with as much negative correlation as possible. This is the best way to hedge away overall (as opposed to individual stock) market risk. As mentioned earlier, the stocks within the funds themselves hedge away individual stock risk, since one of them performing poorly, would be counterbalanced by many other stocks within the same index fund. Index funds, in most cases, provide more than sufficient negative correlation.

The second factor that makes index funds so advantageous to the investor is cost (or low cost). Vanguard’s S&P 500 index ETF, for example, has an expense ratio of  0.05%. That’s 5/100’s of 1% (Full Disclosure: I am a Vanguard client).  The average managed mutual fund charges an expense ratio of over 1% per year. Additionally, it is very common for a managed mutual fund to have a turnover of 100% or more per year. Guess who pays the commission costs to buy and sell within those managed mutual funds?-You do ! Also, it is becoming increasingly common for discount brokerage firms to offer their own index funds and/or others to be purchased commission free, whereas individual stocks almost always have a commission charge.

The third reason index funds are superior, especially to managed mutual funds, is performance. Over a 10-year period, less than 5% of all managed funds ‘manage’ to match or beat a typical index fund tracking one of the major indexes. One of the main reasons for this is the cost differential. The other is the simple fact that over a relatively long period of time (10 years or more), it is very difficult for the vast majority of professional managers to beat the market as it is represented by a typical benchmark.

As educated, experienced and intelligent as most investment managers are, almost all of them still can’t beat the market, as measured by a 100% all-in stock position. Good luck trying to find the very few who can. And even those who do beat the market over a 3 to 5 year period, usually do so primarily because of luck. If you flip a coin 10 times for tens of thousands of “10 flip times”, a few will come up heads ten times in a row. And there are now thousands of managed mutual funds out there. At least as many as there are individual stocks listed on the major exchanges. Every three to five years, a few of them will flip heads ten times in a row.

As increasing numbers of  investors realize these index fund advantages are almost insurmountable over time by almost all managed mutual funds and individual stocks, they will continue to make the switch, as they come to understand these index funds are indeed ‘Indispensable’ to their future financial security.

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