In Part 1 of this series, I discussed how my exhaustive research on investing led me to conclude that low-cost index fund investing is the best way to invest in the stock market. After I reached this conclusion, the next challenge was to decide which index fund or funds I should purchase? I had certainly heard about the well-known S&P 500 Index Fund, which is an index of 500 of the largest U.S. companies listed on the New York Stock Exchange or NASDAQ. But as I immersed myself in the subject of index fund investing, I learned that there are numerous index fund options to consider. Before we talk about some of those options, let’s review a few key definitions from Investopedia that help us to compare index fund investment options on an “apples-to-apples” basis. You may find it useful to reference these definitions as you review the sample index fund portfolios set out below.
- Nominal Return: the amount of money generated by an investment before factoring in expenses such as taxes, investment fees and inflation.
- Real Return: the annual percentage return realized on an investment, which is adjusted for changes in prices due to inflation or other external effects. This method expresses the nominal rate of return in real terms, which keeps the purchasing power of a given level of capital constant over time. Adjusting the nominal return to compensate for factors such as inflation allows you to determine how much of your nominal return is actually real return. The returns shown throughout this article are adjusted for inflation only, and do no factor in taxes and fees.
- Inflation: the rate at which the general level of prices for goods and services is rising and, consequently, the purchasing power of currency is falling. Central banks attempt to limit inflation, and avoid deflation, in order to keep the economy running smoothly.
- Deflation: a contraction in the supply of circulated money within an economy, and therefore the opposite of inflation. In times of deflation, the purchasing power of currency and wages are higher than they otherwise would have been.
- Drawdown: the peak-to-trough decline during a specific recorded period of an investment, fund or commodity. In other words, how far the particular investment has dropped from its peak over a defined period of time.
- Safe Withdrawal Rate: a method that retirees use to determine how much they can withdraw from their accounts each year without running out of money before reaching the end of their lives. The safe withdrawal rate method is a conservative approach that tries to balance having enough money to live comfortably with not depleting retirement savings prematurely.
- Standard Deviation: standard deviation is applied to the annual rate of return of an investment to measure the investment’s volatility. Standard deviation is a statistical measurement that sheds light on historical volatility. For example, a volatile stock has a high standard deviation, while the deviation of a stable blue-chip stock is lower.
- Modern Portfolio Theory: One of the most important and influential economic theories dealing with finance and investment, MPT was developed by Harry Markowitz and published under the title “Portfolio Selection” in the 1952 Journal of Finance. MPT says that it is not enough to look at the expected risk and return of one particular stock. By investing in more than one stock, an investor can reap the benefits of diversification – chief among them, a reduction in the riskiness of the portfolio. MPT quantifies the benefits of diversification, also known as not putting all of your eggs in one basket.
- Negative Correlation: Negative correlation is a relationship between two variables in which one variable increases as the other decreases, and vice versa. In statistics, a perfect negative correlation is represented by the value -1.00, while a 0.00 indicates no correlation and a +1.00 indicates a perfect positive correlation. A perfect negative correlation means the relationship that exists between two variables is negative 100% of the time.
- Bonds: A bond is a debt investment in which an investor loans money to an entity (typically corporate or governmental) which borrows the funds for a defined period of time at a variable or fixed interest rate. Bonds are used by companies, municipalities, states and sovereign governments to raise money and finance a variety of projects and activities.
Analysis of Popular Index Fund Portfolio Options
1. The One Fund Portfolio
If you want to keep your index fund investing very simple, I agree with J.L.Collins that owning the Total U.S Stock Market Index Fund (VTSAX) is a great one fund choice for wealth accumulation. J.L. Collins strongly recommends VTSAX in his book, The Simple Path to Wealth. It is a great read, as is his investing series. By owning VTSAX, you will have exposure to 3,578 companies in the United States at a cost of .05%. How has this fund performed over time? Let’s take a look:
Real Compound Annual Growth Rate Since 1970: 5.9%
Deepest Drawdown: 51%
Longest Drawdown: 13 years
Safe Withdrawal Rate: > 4%
Standard Deviation: 17.2%
A couple of takeaways jump out here. First, this option is aggressive. It is definitely best for younger investors who don’t mind riding the dramatic ups and downs of this dynamic fund choice. As you can see, this portfolio has experienced a maximum drawdown of 51% since 1970! If you’re young, you can view such a downturn as a buying opportunity, purchasing more shares of VTSAX when they are on sale for 51% off!! On the other hand, consider the 13 year drawdown potential – yikes! Many investors (including yours truly) would find it difficult to stay the course if it took 13 years for their VTSAX investment to get back to even.
2. The Two Fund Portfolio
For those who are nervous about having all of their savings in the Total U.S. Stock Market (VTSAX) and also want a smoother ride, the two-fund advocates suggest adding a healthy slice of bonds to the portfolio. Bonds are “negatively correlated” to stocks, meaning that when stock prices are declining bonds tend to go up in value. Stated another way, stocks perform well in times of prosperity while bonds perform best in periods of deflation. How does the classic 60/40 Stocks/Bonds portfolio compare to the one-fund Total U.S. Stock Market portfolio? Here are the results:
Real Compound Annual Growth Rate Since 1970: 5.1%
Deepest Drawdown: 36%
Longest Drawdown: 12 years
Safe Withdrawal Rate: > 4%
Standard Deviation: 11.5%
As you can see, the addition of negatively correlated bonds resulted in a smoother ride, as the deepest drawdown was reduced from 51% to 36%, and the longest drawdown period went from 13 years to 12 years. Overall portfolio risk was reduced, as reflected in the standard deviation change from 17.2% to 11.5%. The cost of the smoother ride was a decrease in the real compound annual growth rate from 5.9% to 5.1%. As you can see, the goal in examining the different portfolio options is to evaluate the risk/return relationship and the overall benefits of diversification.
3. The Three Fund Portfolio
Let’s try one more in today’s post — the very popular three fund portfolio. This option was made popular by the “bogleheads“. It consists of the Total U.S. Stock Market (40% VTSAX), the Total International Stock Market (20% VTIAX), and the Total Bond Market (40% VBTLX). Although some investors believe that direct international stock exposure is unnecessary due to the fact that many U.S. companies sell their products all over the world, others maintain that exposure to companies based outside the U.S. adds a healthy dose of diversification and negative correlation that benefits the overall performance of a portfolio in a positive way. Let’s take a look at the results:
Real Compound Annual Growth Rate Since 1970: 5.0%
Deepest Drawdown: 34%
Longest Drawdown: 12 years
Safe Withdrawal Rate: > 4%
Standard Deviation: 11.2%
As illustrated by the results, the three fund portfolio has similar results to the two fund alternative, but reduces both drawdown and standard deviation without a major sacrifice in the real compound rate of return (5.1% vs. 5.0%).
4. Other Options
I could do this all night (yes I’m a nerd), but at the risk of losing your attention, let me share a wonderful graph that comes from www.portfoliocharts.com, my VERY FAVORITE investing website. All of my data in this blog post comes from that wonderful site. I cannot recommend it highly enough. At portfoliocharts.com you can analyze virtually any combination of asset classes and get instant historical data accompanied by incredibly helpful charts and graphs. If you visit once I promise you’ll be hooked for life! Anyway, here is one of my favorite graphs from the site that illustrates the minimum real 15-year compound annual growth rates since 1972 for a variety of today’s most popular index fund portfolios!
As you can see from the above information, index fund investing does not have to be complex. It is very possible to design a simple portfolio using as little as 1 to 3 index funds. I would love to here your thoughts on index fund investing.
Next time, I will move from the general to the specific by laying out my personal investment allocations for your review. Don’t forget to check out portfoliocharts.com. Happy Easter everyone!