Long version: The basic argument for index funds over individual stocks is that you think that a is going to outperform a because of general economic growth and reduced risk through pooling. So if you apply the same logic to index funds, what that argues is that you should find the index fund that covers the largest possible pool.
But it also becomes obvious that this logic only stretches so far—one might think that meta-indexing requires having a stock index fund and a bond index fund that are both held in proportion to the total value of stocks and bonds. So let’s start looking at the factors that push in the opposite direction.
First, historically stocks have returned more than bonds long-term, with higher variability. It makes sense to balance your holdings based on your time and risk preferences, rather than the total market’s time and risk preferences. (If you’re young, preferentially own stocks.)
As well, you might live in the US, for example, and find it more legally convenient to own US stocks than international stocks. The corresponding fund is VTSMX, for the total US stock market. If you want the global fund, it’s VTWSX.
You might have beliefs about small caps and large caps, or sectors, and so on and so on. One mistake to avoid here is saying “well, I have three options, so clearly I should put a third of my money into each option,” especially because many of these options contain each other—the global fund mentioned earlier is also a US fund, because the US is part of the globe.
Asset allocation (what portion of your money is in stocks and bonds) is very important, depends on your age, and will get out of whack unless you rebalance. So use a Vanguard Target Retirement Date fund.
Yes, but those are the important ones. Stocks for high expected returns and bonds for stability. You can generalize “bonds” to include other things that return principal plus interest like cash and CDs.
Important to the goal of increasing one’s wealth while managing the risk of losing it. Certainly there are other possible goals (perhaps maximizing the chance of having a certain amount of money at a certain time, for example) but this is the most common, and the one that I assume people on LW discussing basic investing concepts would be interested in.
Um.… I hate to break it to you...
I’m not sure if you’re referring to the fact that popular banks are returning virtually zero interest or if you’re interpreting “cash” as “physical currency notes”. If the former, I have cash in bank accounts that return .01%, 1%, and 4.09% (each serving different purposes). If the latter, I apologize for the confusion. The word is used to mean different things in different contexts. In the context of investing it is standard to include in its meaning checking and savings accounts, and often also CDs.
Important to the goal of increasing one’s wealth while managing the risk of losing it.
Given this definition, I don’t see why only stocks and bonds qualify.
The word is used to mean different things in different contexts.
True, but given that you said “cash and CDs” I thought your idea of cash excludes deposits. Still, there are more asset classes than equity and fixed income.
Given this definition, I don’t see why only stocks and bonds qualify.
My claim is that equity and fixed income are the important pieces for reaching that goal. With a total stock index fund and a total bond index fund you can achieve these goals almost as well as any other more complicated portfolio. Additional asset classes can add additional diversification or hedge against specific risks. What other asset classes do you have in mind? Real estate? Commodities? Currencies?
True, but given that you said “cash and CDs” I thought your idea of cash excludes deposits.
My claim is that equity and fixed income are the important pieces for reaching that goal.
They are, of course, important. The question is whether they are the only important pieces.
What other asset classes do you have in mind
Real estate is the most noticeable thing here, given how for a lot of people it is actually their biggest financial investment (and often highly leveraged, too). Commodities and such generally require paying at least some attention to what’s happening and the usual context of financial discussions on LW is the “into what can I throw my money so that I can forget about it until I need it?”
I have a secondary question to that. These things seem to all operate online only, without bricks and mortar. How do I assure myself that a website that I have never seen before is trustworthy enough to invest, say, 6-figure sums of money in? Are there official ratings or registers, for probity rather than performance?
That’s easy to answer for Vanguard, which has been around since 1975 and has $3T under management. It’s not going anywhere. Both Wealthfront and Betterment were founded in 2008, in Palo Alto and NYC respectively, and have about $2B and $3B under management. I don’t think there are any official ratings of probity out there; I’m not sure there’s a good source besides trawling through the business press looking for red flags.
You may want to check if the brokerage firm/custodian is a member of SIPC, which provides a level of insurance against misappropriation. I think all the big names are members (Vanguard, Schwab, TD Ameritrade, Fidelity, etc.)
The best argument for getting an index fund is the expense ratio; not broad versus narrow. Managed mutual funds have higher expense ratios because of the broker’s salary. Private trading instead of buy and hold will similarly cost you more because of the transaction cost. To justify their transactions, a broker doesn’t just have to beat the market, but to beat the market by a large enough swing to justify those extra costs. Because of the number of brokers out there, even if one has consistently beaten the market, it is impossible to determine whether that is due to skill or luck for any given broker. Large domestic index funds will generally have the lowest expense ratios.
So, I think the correct answer to the question “I have a 5-figure sum of money to invest” is to just go with Betterment/Wealthfront rather than Vanguard, so that you get diversification between asset classes (whereas a specific index fund will get you diversification within an asset class). If I’d known this when I’d asked the question, I would have picked a better mix of Vanguard index funds, and not hesitated as much with figuring out where to put the money. To be fair, Vaniver basically said this, I just think the links below explain it better, so I could feel certain enough to make a decision rather than let the money burn away through inflation.
You need to figure out things like your own risk tolerance, your own time horizons for investments, and your own ideas about what might happen (or not) in the econo-financial world within your time horizons.
I have a secondary question to that. These things seem to all operate online only, without bricks and mortar. How do I assure myself that an online website that I have never seen before is trustworthy enough to invest, say, 6-figure sums of money in? Are there official ratings or registers, for probity rather than performance?
So, it seems like lots of people advise buying index funds, but how do I figure out which specific ones I should choose?
Short version: try something like Vanguard’s online recommendation, or check out Wealthfront or Betterment. Probably you’ll just end up buying VTSMX.
Long version: The basic argument for index funds over individual stocks is that you think that a is going to outperform a because of general economic growth and reduced risk through pooling. So if you apply the same logic to index funds, what that argues is that you should find the index fund that covers the largest possible pool.
But it also becomes obvious that this logic only stretches so far—one might think that meta-indexing requires having a stock index fund and a bond index fund that are both held in proportion to the total value of stocks and bonds. So let’s start looking at the factors that push in the opposite direction.
First, historically stocks have returned more than bonds long-term, with higher variability. It makes sense to balance your holdings based on your time and risk preferences, rather than the total market’s time and risk preferences. (If you’re young, preferentially own stocks.)
As well, you might live in the US, for example, and find it more legally convenient to own US stocks than international stocks. The corresponding fund is VTSMX, for the total US stock market. If you want the global fund, it’s VTWSX.
You might have beliefs about small caps and large caps, or sectors, and so on and so on. One mistake to avoid here is saying “well, I have three options, so clearly I should put a third of my money into each option,” especially because many of these options contain each other—the global fund mentioned earlier is also a US fund, because the US is part of the globe.
Asset allocation (what portion of your money is in stocks and bonds) is very important, depends on your age, and will get out of whack unless you rebalance. So use a Vanguard Target Retirement Date fund.
There are more financial assets than just stocks and bonds.
Yes, but those are the important ones. Stocks for high expected returns and bonds for stability. You can generalize “bonds” to include other things that return principal plus interest like cash and CDs.
What’s the criterion of importance?
Um.… I hate to break it to you...
Important to the goal of increasing one’s wealth while managing the risk of losing it. Certainly there are other possible goals (perhaps maximizing the chance of having a certain amount of money at a certain time, for example) but this is the most common, and the one that I assume people on LW discussing basic investing concepts would be interested in.
I’m not sure if you’re referring to the fact that popular banks are returning virtually zero interest or if you’re interpreting “cash” as “physical currency notes”. If the former, I have cash in bank accounts that return .01%, 1%, and 4.09% (each serving different purposes). If the latter, I apologize for the confusion. The word is used to mean different things in different contexts. In the context of investing it is standard to include in its meaning checking and savings accounts, and often also CDs.
Given this definition, I don’t see why only stocks and bonds qualify.
True, but given that you said “cash and CDs” I thought your idea of cash excludes deposits. Still, there are more asset classes than equity and fixed income.
My claim is that equity and fixed income are the important pieces for reaching that goal. With a total stock index fund and a total bond index fund you can achieve these goals almost as well as any other more complicated portfolio. Additional asset classes can add additional diversification or hedge against specific risks. What other asset classes do you have in mind? Real estate? Commodities? Currencies?
Fair enough. I was unclear.
They are, of course, important. The question is whether they are the only important pieces.
Real estate is the most noticeable thing here, given how for a lot of people it is actually their biggest financial investment (and often highly leveraged, too). Commodities and such generally require paying at least some attention to what’s happening and the usual context of financial discussions on LW is the “into what can I throw my money so that I can forget about it until I need it?”
I have a secondary question to that. These things seem to all operate online only, without bricks and mortar. How do I assure myself that a website that I have never seen before is trustworthy enough to invest, say, 6-figure sums of money in? Are there official ratings or registers, for probity rather than performance?
That’s easy to answer for Vanguard, which has been around since 1975 and has $3T under management. It’s not going anywhere. Both Wealthfront and Betterment were founded in 2008, in Palo Alto and NYC respectively, and have about $2B and $3B under management. I don’t think there are any official ratings of probity out there; I’m not sure there’s a good source besides trawling through the business press looking for red flags.
You may want to check if the brokerage firm/custodian is a member of SIPC, which provides a level of insurance against misappropriation. I think all the big names are members (Vanguard, Schwab, TD Ameritrade, Fidelity, etc.)
http://www.sipc.org/for-investors/what-sipc-protects
The best argument for getting an index fund is the expense ratio; not broad versus narrow. Managed mutual funds have higher expense ratios because of the broker’s salary. Private trading instead of buy and hold will similarly cost you more because of the transaction cost. To justify their transactions, a broker doesn’t just have to beat the market, but to beat the market by a large enough swing to justify those extra costs. Because of the number of brokers out there, even if one has consistently beaten the market, it is impossible to determine whether that is due to skill or luck for any given broker. Large domestic index funds will generally have the lowest expense ratios.
So, I think the correct answer to the question “I have a 5-figure sum of money to invest” is to just go with Betterment/Wealthfront rather than Vanguard, so that you get diversification between asset classes (whereas a specific index fund will get you diversification within an asset class). If I’d known this when I’d asked the question, I would have picked a better mix of Vanguard index funds, and not hesitated as much with figuring out where to put the money. To be fair, Vaniver basically said this, I just think the links below explain it better, so I could feel certain enough to make a decision rather than let the money burn away through inflation.
http://www.mrmoneymustache.com/2012/02/17/book-review-the-intelligent-asset-allocator/
http://www.mrmoneymustache.com/2014/11/04/why-i-put-my-last-100000-into-betterment/
MMM is in general excellent, and that’s convinced me to move Betterment above Vanguard in my recommendation list in the future.
You need to figure out things like your own risk tolerance, your own time horizons for investments, and your own ideas about what might happen (or not) in the econo-financial world within your time horizons.
I have a secondary question to that. These things seem to all operate online only, without bricks and mortar. How do I assure myself that an online website that I have never seen before is trustworthy enough to invest, say, 6-figure sums of money in? Are there official ratings or registers, for probity rather than performance?