Invariably, when markets are volatile, and it seems as if no single investment strategy is keeping up with the market indexes, we get questions from clients asking whether an index fund would be a preferable investment. Quite often these questions are driven by comments in the financial press that some index funds seem to be outperforming many actively-managed stock mutual funds or individual stock portfolios that many of our clients have. The conclusion often reached by these articles—or pundits—is, “if it is so difficult, why bother?”
To determine the path of investing that may be right for you requires the careful weighing of many factors. The primary, and often limiting, issue is one of asset levels that an investor has to commit to equity (stock) in their portfolio. At Henssler Financial, we advocate using our Ten Year Rule to determine the mix of equity and fixed investments that should be appropriate for your portfolio. Once the level of equity is decided upon, generally, we recommend that no more than 5% of your portfolio be invested in any one common stock. To be properly diversified, you should own 10 to 16 different stocks in at least six to eight sectors.
When contemplating which individual stocks to choose, the first consideration is that of quality. To build a quality portfolio, an investor should begin by looking deep into the financials of a company. For Henssler Financial, only about 60% of the stocks in the S&P 500 make the cut. This allows us to begin to identify companies that should withstand hard times, unexpected downturns in the economy, and protracted deviations from profitable business cycles. When the economy is rolling along fine, you can find all kinds of stocks moving up regardless of quality. It becomes “a rising tide lifts all boats” scenario, and it’s easy to make money. The problem (or opportunity) arises when times are not so good. Then it really depends on fundamentals and discipline. And of course, rarely do you see those hard times coming until you are in the middle of them.
By jumping into an index fund of any type, the investor is abdicating this selection process to one of just the sheer size of a company, or some other objective qualifier that does not take into account the quality of a company. Because of the composition of an index, many times an index fund investor is overweighted in a select few companies. Most investors are not aware of the concentrated positions of many index funds and the risk associated with this concentration. Many mutual fund managers find it difficult to stick to a discipline of quality stocks when the “rising tide” scenario is playing out. For the short run, performance is often a matter of luck more than skill. But in the long run, which is the important view, quality usually wins.
Other factors need to be considered when deciding how to invest. If you have taxable accounts, individual stocks can have the advantage. You can control much of the taxable implications of stock investing. Additionally, the amount of time you can commit to overseeing your portfolio is an important consideration. If you have individual stocks, we strongly suggest that you consider a fee-only manager to oversee and/or manage your portfolio. If you do not wish to hire an adviser, and you do not have the time or inclination to do this yourself, then index funds could be a viable option. Of course the portfolio, by definition, will now perform “average” or a little less, when fees are considered.
It is our belief that when an investor is committed to the long term, they do better, and that is what is important. For more information on index funds, please contact Henssler Financial at 770-429-9166, or [email protected].