Index fund investing is as popular as ever. In 2014, Vanguard alone recorded record mutual fund inflows totaling $216 billion. Investors are catching on to the benefits of index and other passively managed funds – benefits that include lower costs, broader diversification, lower turnover, and greater transparency.
But, as Wall Street Journal columnist and author Jonathan Clements pointed out back in 1997, “Indexing is a wonderful strategy. It’s a shame most folks do it wrong.” He goes on to explain:
“Investors should use index funds to build global stock market portfolios. Unfortunately, most investors aren’t building global portfolios. Instead, they are betting on one type of index fund, those that buy the stocks in Standard & Poor’s 500-stock index.”
In other words, there’s more to index fund investing than simply throwing all of your money into an index fund that tracks the S&P 500 (which tracks the performance of the stocks of large companies based in the U.S.) These funds, such as the Vanguard 500 Index Fund or the SPDR S&P 500 ETF Trust, ignore 70% of the world equity markets and do not include any fixed-income investments.
To illustrate Clements’ point, let’s examine two hypothetical 65-year-olds who celebrated the arrival of the new millennium by retiring on December 31, 1999, with a $1,000,000 retirement nest egg. Each retiree plans to withdraw $50,000 during the first year in retirement, and continue doing so each subsequent year with a 2% inflation adjustment.
The first retiree understands the benefits of index funds and proceeds to invest his entire nest egg in the Vanguard 500 Index Fund.
The second retiree also understands the benefits of index funds but divides his retirement funds across three broad-based index funds: 50% in the Vanguard Total Stock Market Index Fund, 25% in the Vanguard Total International Fund, and 25% in the Vanguard Total Bond Market Fund. At the end of each year, he rebalances the account.
Unfortunately for these retirees, they retired immediately prior to the “dot-com” stock market crash of 2000-2002. And just five years later, they had to endure yet another major crash during the great financial crisis of 2008.
So how did these retirees fare assuming they did not change course?
As of December 31, 2013, the first retiree ended the year with approximately $209K left in his nest egg, which represents less than four years of retirement withdrawals. Needless to say, at age 78, he is in big trouble.
The second retiree who implemented a three fund globally diversified portfolio ended 2013 with approximately $596K remaining. By building a more diversified portfolio of index funds and rebalancing annually, he has enough funds to last another 10-12 years.
Now suppose there is a third retiree who also implemented a diversified portfolio of index and low cost passively managed funds. But with the help of an advisor, he diversified further across small and value risk factors as well as real estate securities. The result? Even after an annual 75 basis point investment advisory fee, the retiree ended 2013 with $902K in his nest egg.
So it turns out that Mr. Clements’s advice back in 1997 was prescient given the difficult market environment that was right around the corner. Our hypothetical retiree who put all of his retirement savings in the S&P 500 index fund may have thought he was diversified and may have thought he was being prudent, but what he was really doing was placing a bet – a bet he unfortunately lost.