Indexing Is The Way To Go

Photo by Markus Winkler / Unsplash

Investors have a temptation to jump from stock to stock seeking for the best opportunities, but most of the time this just leads underwater. Don’t waste your time when you can get market returns without any effort.

I myself must admit how boring it is to buy stocks and keep them forever. The difference between gambling and investing comes at exactly this part. Investing is boring. Gambling is thrilling. But, if your main goal is making money in a systematic way over time, then you may have to accept some boringness.

Research in finance has systematically been showing that the worst enemy of an investor is transaction costs. Jumping from stock to stock is costly because your broker would charge you fees to buy and to sell. Additionally there are embedded fees in trading, which come in the form of bid-ask spreads. For example, Evraz Plc is currently quoted as 499.70 – 500.20. It means that if you buy and sell instantly, you buy at 500.20 and sell at 499.70, for a loss of .50 in 500.20 invested. In this particular case the cost represents 0.1% of your investment. If you trade substantially, or if you jump from a FTSE 100 stock to a small cap stock, the costs start rising and will drag down your performance.

There’s another important point against you, which is taxes. Depending on the jurisdiction, taxes may be higher or lower but, in general, every time you sell a winner you are liable for paying taxes on capital gains. In some jurisdictions, taxes are lower for long-term holdings, which means that the higher the turnaround of your portfolio, the less tax efficient it will be.

Apart from transaction costs and taxes, you still need to beat the market. The only reason to spend time and money jumping from stock to stock is to get above-average returns. Unfortunately that’s a quite demanding task, even though many investment advisers and fund managers advertise it as common. Those who are able to beat the market at one time usually are the same who underperform at another time. Research has been unable to find alpha out of active management.

However, for those of you who don’t want to spend your leisure time seeking for ways of systematically beating the market, there’s still hope. It comes in the form of passive investing. You can always buy a broad market Exchange Traded Fund (ETF) and, at least, get market returns.

Passive investing has been growing and the offer is now vast. You can invest in broad market indexes like the S&P 500, the Russell 2000, or the FTSE All-Share. Additionally, you can follow some specific industries like Oil & Gas or specific themes like Artificial Intelligence. The great advantage is that most of these ETFs offer pre-made portfolios that achieve the diversification you would never get by investing by yourself. At the same time these portfolios face much lower transaction costs and are more tax efficient.

Instead of buying specific stocks, you can buy different ETFs that can work as layers in your portfolio. This way you avoid something that the Modern Portfolio Theory taught us long ago to avoid – diversifiable risk. If we believe pharmaceuticals will do well under the pandemic, then we better invest in a pack of different companies instead of putting all eggs in just one. Let’s say we invest in Pfizer alone and something goes wrong with a vaccine development. While pharmaceuticals as a group may do well, it may be the case Pfizer doesn’t. If that’s the case, we would have guessed it right about pharmaceuticals but had the misfortune of choosing the wrong outfit. This misfortune is called diversifiable risk and we can get rid of it by diversifying. If we don’t have enough funds to buy a portfolio of companies, then we may get it for cheap using an ETF.

With all this in mind, to build a well diversified portfolio, you just need two assets: a broad-based stock ETF and a bond ETF. For the simplest case scenario, all we need is Vanguard Total Stock Market (NYSEARCA:VTI) and Vanguard Total Bond Market ETF (NASDAQ:BND). VTI tracks the performance of the CRSP US Total Market Index, investing across more than 3,500 U.S. stocks, covering small, mid and large caps and both value and growth stocks. This gives you an exposure to the US broad stock market. BND provides broad exposure to the taxable investment-grade U.S. dollar-denominated bond market, investing in almost 10,000 bonds with an average duration of 6.7 years.

Fig.1 - Vanguard Total Market ETFs

The annual fees charged by Vanguard are 0.03% for VIT and 0.035% for BND. Remember from the bid-ask example depicted above that you would pay 0.1% to trade Evraz? Now include brokerage fees and the time spent to research and conduct the trades…

Instead of Vanguard, you may look at other companies, like BlackRock, for example. They offer iShares Core S&P Total U.S. Stock Market ETF (NYSEARCA:ITOT) and iShares Core Total USD Bond Market ETF (NASDAQ:IUSB), which would be the equivalent to VIT and BND. You could also look at a global exposure instead of an US exposure and then you would look at Vanguard Total World Stock ETF(NYSEARCA:VT) and Vanguard Total World Bond ETF (NASDAQ:BNDW). There are many other options.

After selecting the above two ETFs, all you have to do is to decide on the proper allocation between them. Younger investors starting a savings plan earlier in life may opt for a higher allocation into the stock part, like 70-30 or even 80-20 to VTI/BND. Older investors, near retirement, or with a lower tolerance towards risk may opt for a 50-50 or even a 40-60 allocation to VTI/BND. The reason for these different allocations is because the stock market carries more risk than the bond market over shorter periods of time. Fig. 1 helps understand this. At the beginning of the covid-19 pandemic, there was a sudden decline in the stock market that brought VTI down more than 30% in the year. While that happened, BND held its value quite well. Fortunately, it was the case for a quick recovery, which isn’t always the case. For older people near retirement, a drop of 30% is way too much to recover in the time left for their investment horizon. For younger people, there’s in general plenty of time for a turnaround.

Irrespective of your risk tolerance, you may always opt for a broad-based stock market fund and a bond fund to build your portfolio. Tolerance towards risk will then dictate the proper allocation between these and, under certain scenarios, may lead some investors to take some leverage.

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