For many years, the default advice to the average individual investor has been "buy an index fund." While that's not bad advice, exactly -- better than "just buy this equity-indexed annuity" or "you should play three-card monte with me" -- I've always found it problematic, for reasons that ---
Wait. Stop.
What?
You're dissing index funds? You can't do that! What is this nonsense?
I'm not "dissing" them, exactly. It's just that they're kind of a cop-out.
A "cop-out"? Index funds aren't a cop-out. A cop-out is when people say they "don't have time" to set up their 401(k) contributions at work because they're too busy doing important stuff like playing Minesweeper. Buying an index fund is taking action, what you're always telling everybody to do. How is that bad?
It's not bad. It's certainly better than leaving long-term savings in cash, or in some lousy actively managed fund with huge fees. In fact, sometimes it's the best thing you can do in certain situations -- like if it's the least stinky option in your 401(k) plan. But in an IRA, or your regular brokerage account... there are just so many better options.
What do you mean? I've got Vanguard 500 Index Fund (VFINX) in my brokerage account. I figure I own the best 500 stocks in the market without having to do any work.
Well, you own something that tracks 500 stocks. But let me ask you this: What's the biggest company in the index?
What?
ExxonMobil (NYSE: XOM). It's more than 3% of the index all by itself. Now, ExxonMobil is a great company, but if you were going to pick one oil company to have 3% of your portfolio in, would that be the one?
I dunno. It's a good company I don't have to worry much about, but so is BP (NYSE: BP), and it pays a better dividend. But I guess I don't mind owning ExxonMobil.
How about Johnson & Johnson (NYSE: JNJ) at No. 4? That's less than 2% of the portfolio, but it's over 14% of your whole health care sector position. Health care is about an eighth of your fund's portfolio, and there are more than 50 companies in there. Some are good, some are stinkers. But overall, they're mostly big names and slow movers. It's a whole big bucket of average.
But what if you had taken a piece of that 14% and bought an innovative up-and-coming health-care stock like Vascular Solutions (Nasdaq: VASC) instead?
Well, I might make a lot more money. But I'd have a lot more risk.
You might. But you could take some of that money and also buy J&J, which is a fine blue-chip choice, to offset the risk of the smaller stocks. In other words, you could build your own little health care sub-portfolio with just the stocks you want.
Yeah, but what if I don't have any good stock ideas for a particular sector?
Then you can buy a sector ETF as a placeholder until you come up with something better. Like maybe you're not sure what you want to do in the technology sector, so you buy an ETF like iShares S&P North American Technology. The top 10 holdings make up over half of the fund, and they're all the big names -- like Amazon.com (Nasdaq: AMZN) and Google (Nasdaq: GOOG), both of which are fine companies to sit on while you figure out what companies are likely to be the next Amazon and Google.
I'd love to do that, but it sounds like a lot of work. More work than the index fund!
Well, another way to look at it is that the big index fund is the lazy way to go. It's easy, and it's better than sitting in cash most of the time, but when you buy a big bucket of average, average returns are what you get. If you want to be above average, that takes effort.
OK. So say I want to find the next Amazon or Google. How do I do that?
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