Ask HN: Does an index fund count as diversifying?

10 points by bryanalves 16 years ago | 20 comments

So, I'm average joe programmer. I contribute to 401k, and I have a high yield savings account for very short term stuff. I would like to start investing in something that will be usable in the short-medium term.

I don't know much at all about the stock market, and don't want to learn. I am thinking about putting some fixed amount of money per month in a single index fund (a large, broad index fund).

Is this enough in terms of diversification, given my other investments? Goal is to either:

1. Be able to take the money out in short-medium term (3-6 years maybe) as a down payment for a house 2. Go "all the way" and provide funding for an early retirement.

Is contributing $100ish per month through a standard online broker (scottrade, etrade, sharebuilder, whatever), to a single index fund a smart choice for somebody like me?

Some base stats: Age: 26 Immediate liquid capital: low 5-figures, enough for 6 months of living, in a random high-yield savings. 401k contributions: ~10k/year

The obvious "put more in 401k" I don't think applies to me. I am already contributing a pretty substantial amount, and I would like to potentially have access to the money much sooner than a 401k would allow. Picking a single index-fund seems to make sense for me, since I'm going to be doing repeated small contributions, and thus will save on brokerage costs.

AAAAAAAAND I'm rambling. Any advice would be appreciated.

sivers 16 years ago |

Please read this very tiny succinct powerful book: http://sivers.org/book/SmartestInvestmentBook

I put my notes on that page, but the real book is really worth reading. It sums up the wisest advice about passive investing so well.

Don't go with one fund. Do three:

#1 = An index fund representative of the US stock market in its broadest terms. (Fidelity: FSTMX, Vanguard: VTSMX)

#2 = An index fund representative of the international stock market in its broadest terms. (Fidelity FSIIX, Vanguard: VGTSX)

#3 = An index fund representative of the US bond market in its broadest terms. (Fidelity: FBIDX, Vanguard: VBMFX)

ASSET ALLOCATION:

LOW RISK = 14% stocks, 6% int'l stocks, 80% bonds

MEDIUM-LOW RISK = 28% stocks, 12% int'l stocks, 60% bonds

MEDIUM-HIGH RISK = 42% stocks, 18% int'l stocks, 40% bonds

HIGH RISK = 56% stocks, 24% int'l stocks, 20% bonds

(NOTE: all stock-holdings are 70% domestic, 30% international. Only choice is how much are stocks and how much are bonds.)

tocomment 16 years ago | |

Question I've been wondering. Is it ok to buy into a bond fund like VBMFX right now in this low interest rate environment?

If interest rates go up a lot in a year or two will my share price drop a lot and cancel out any gains from interest?

bricestacey 16 years ago |

No single fund is truly diversified. For example, the Vanguard Total Stock Market Fund offers stocks across all industries and includes growth and value companies from domestic and international, large, mid, and small-cap companies. That's pretty darn diverse, but it only covers stock. To really diversify, you may want to purchase a bond index as well.

I use Vanguard. Vanguard has some of the lowest cost index funds. The only downside is they all have $3000 (or more) initial limits. Oh and there are generally no transaction costs with Vanguard, so you could do $100 a month via direct deposit and personally incur no fees.

jbellis 16 years ago | |

> The only downside is they all have $3000 (or more) initial limits

That's what ETFs are for, among other things.

> there are generally no transaction costs with Vanguard

(but you do lose that part w/ any ETF)

brk 16 years ago |

Most online places charge about $10 per trade. So even if you're putting $200/mo in, you're losing 5% immediately. Best choice would be to save up for several months and do fewer trades.

You really need to do better research, your statement that you don't want to learn about the stock market is a good way to guarantee that you never really make the kinds of returns you should. If there was a reliable, easy no-knowledge way to grow your investments, people would already be doing that.

A better option may be to look at some money market accounts. We have accounts with Ford Motor Credit and GMAC (now Ally). Check out http://www.ally.com/money-market-account/index.html it's not going to be the highest possible return rate, but there are no fees for "investing" your money, the funds are liquid, and as you get to higher balances you can get better returns. This is where we keep our "accessible" funds (low 6 figures).

Also, I'm not sure how much you're contributing to your 401K, but it may be worth bumping that up as well. You should probably at least be doing 10% of salary.

High-yield CDs would also be something to look at.

In short, for the dollars you're talking about, I would NOT consider anything that charged a transaction or maintenance fee, it would eat up any potential earnings.

CoreDumpling 16 years ago | |

> Most online places charge about $10 per trade.

I think the OP is talking about index funds, not stocks. If you invest in the fund that your broker manages, there usually isn't such a "purchase fee" for index funds, only some of the more risky funds that want you to demonstrate that you're willing to eat some losses in hopes of a bigger payout later. The bigger fees tend to be associated with more active management, which generally doesn't apply to funds that simply track an index.

I've never been charged this transaction fee on Fidelity Spartan 500 (or whatever it is called now), for example. Vanguard also has a pretty good reputation for their low- or no-fee funds.

natrius 16 years ago | |

Honest question: What's the logic behind keeping hundreds of thousands of dollars in a money market account? Is there a larger chunk of money sitting in places that earn a better return? If I had that kind of money sitting around that I wanted to use in the next couple of years, I can't imagine putting it in anything with less of a return than the low-risk Vanguard core funds. I don't know much about these things, so if I'm wrong, I'd like to know before I have money to lose.

brk 16 years ago | | |

When I said low 6 figures, I meant very low. We don't usually keep more than $150,000 (and it varies between $60K and $150K as things cycle) in "accessible cash". This is, for us, funds used to purchase a new vehicle, or deal with some around the house issues, or move to a new investment opportunity.

This is just an amount that, for our purposes, is enough to cover most random unanticipated issues without keeping too much money uninvested.

natrius 16 years ago |

If your employer isn't matching that entire $10k, you should look into other retirement options.

http://www.iwillteachyoutoberich.com/blog/the-worlds-easiest...

"First, I would max out any 401(k) match that my company provides. Second, I’d max out the $5,000 for my Roth IRA. Third, I’d max out the rest of my 401(k), up to $15,000. Finally–if your employer doesn’t offer a 401(k), you’re not employed yet, or you still have money left over–I’d open a regular, taxable investment account and put money there in stocks, index funds, etc.

Why max out your Roth before your 401(k)? Well, there’s a lot of dorky debate in the personal-finance world, but the basic reasons are taxes and tax policy: Assuming your career goes well, you’ll be in a higher tax bracket when you retire, meaning that you’d have to pay more taxes with a 401(k). Another common reason for the Roth is that tax rates are considered likely to increase. Remember: Your 401(k) money is taxed at the end, while Roth money is taxed right away and then grows tax-free."

jessriedel 16 years ago | |

Besides considering (1) the current-tax-rate vs. retirement-tax-rate and (2) tax rates are likely to increase, the other major thing to keep in mind is (3) that the government may decide to tax Roth IRA distributions in the future (even though it says it won't now).

Think it won't happen? Social security benefits weren't taxed until 1984.

EDIT: Also, if you're currently raising a family and/or paying for kids' college, it's very plausible and reasonable that you'll be in a lower tax bracket when you retire.

CraigBuchek 16 years ago | |

This is the advice I've seen from just about every financial adviser, for anyone not near retirement age.

Another nice thing about a Roth IRA is that you can withdraw all the principal (the part you already paid taxes on) early with no penalty. (Actually, you can withdraw the interest from individual accounts -- you just can't withdraw more than you put into ALL your Roth IRAs.) Although my bank seems to not understand this very well, and the government forms aren't very clear on it either.

RobGR 16 years ago |

I don't think it is a good idea for a individual to put money in the stock market, whether as you are doing now (via your 401k) or through some other method.

In theory, the stock market should be a place where companies can raise money to carry out enterprises that return more money to the stock holders. In order to be able to raise money from more people, rules are applied that make sure the powerful and rich don't rip off the weak; this is how the original stock markets, certain coffee houses in London and Amsterdam, fell upon the idea of only admitting members who agreed to record all of their transactions upon a chalk board on the wall, open for all to see.

In the current reality, companies don't pay dividends, when you buy the stock the money you pay is not going to go to the company to fund any enterprise, and well connected people at Goldman Sachs employ "high frequency trading" which is essentially shill bidding in an open-outcry auction.

The people who thought "high frequency trading" was OK are still in charge of the stock market; I'm not sure if they currently claim that is stopped or not, but it doesn't matter, the people who failed the test of allowing it in the first place are still in charge. Had they been selling cattle as a licensed auctioneer, and allowed that sort of thing to go on, they could go to jail.

Other places to put your money could include government bonds; you might look at the inflation protected series of bonds. You could simply keep your money in an FDIC insured savings account. As long as you are thinking you might need the money in 3 to 6 years, anything else seems foolish.

bryanalves 16 years ago |

Thanks for the resources guys. It sounds like I need at least a couple of index funds to be adequately diversified, and the books that have been mentioned here have been mentioned in numerous other places that I've seen; time to give them a look and spend at least a little time learning.

As for the people talking about not taking the time to learn, I understand that I'm not going to have crazy returns or anything like that. I just want an investment vehicle that will outperform basic savings accounts and such, and, hopefully, beat inflation.

Also, as for people saying "don't put money in the stock market if you need it in 3-6 years." I certainly won't need it; I was more emphasizing that I want something sooner than 401k, and potentially would like to have it available that soon. T

he more realistic scenario is I use it as a gap retirement fund. I'm 26 now, and would be happy to retire in 25-30 years. This means I need 10-15 years of gap money before 401k becomes viable.

Vanguard has been mentioned multiple times in this thread. I used to have a 401k with them, with a previous employer, but I didn't pay much attention to their offerings. For passively dumping small amounts of money into a small set of ETFs monthly, do they offer a superior service to some of the other online brokers that I mentioned?

nickelplate 16 years ago |

It is impossible to answer this question without knowing what kind of index fund you are investing in ("large, broad index fund" does not say much). For example, if you buy an S&P 500 index fund, you are not indexing the stock market. You're just indexing a bunch of blue-chip US stocks, and you don't have exposure to asset classes such as bonds, small cap equity or foreign equity.

If you will need the money in 3-6 years you should not put it in the stock market. If you want to fund an early retirement then there are a lot more variables into this equation that you do not seem to take into consideration. What is "early"? How much money will you need into retirement? What other source of income besides savings will you have during retirement? Do you intend to raise a family? Etc. It is impossible for anyone to answer these questions for you. This is why you should learn about the stock market, and about personal investing in general, if you want to make informed decisions about making your money work for you.

I very strongly suggest that you read "A Random Walk Down Wall Street" by Burton Malkiel.

iamelgringo 16 years ago |

Someone double check my information on this, but I believe that you can take a 10,000 withdrawl penatly free for a first time home purchase. The distribution will still be taxed, but there is no penalty.

ConsumerReports.org usually has a pretty good list of low load, no load index and mutual funds that they suggest. They are a non profit, and I'd been consistently pleased with their advice over the years.

elidourado 16 years ago |

Broad index funds are great, but the big problem with them is that all your eggs are still in the "USA basket". Consider adding some foreign or emerging market funds, but also realize that it is impossible to diversify perfectly.

ww520 16 years ago |

Max your Roth IRA for now. Judging from your current contribution level, you are still qualified.

Check out Permanent Portfolio if you have more money.

Get into real estate if you can. I participated in the last great real estate run-up and benefited greatly.

tocomment 16 years ago |

Maybe do half s&p 500 index fund and half vanguard bond fund. That way you're more diversified.

gcb 16 years ago |

I hear a lot of 401k.

Anyone have any experience with it while not being a us citizen?

E.g. Work in the US for some yrs and then leave for good.