When you condense a wealth of financial knowledge into 10 “rules,” you’re taking part in a process known as “simplification.” Perhaps not ironically, that happens to be Fortune Magazine’s third rule for building wealth.
Choosing three or four index funds – say, an S&P 500 fund, an EAFE fund, and a small-cap stock fund – will give you broad exposure.
Diversification in equities has proven to be the best way to achieve high returns in exchange for little risk over the long term. The combination suggested exposes investors to American companies of a variety of sizes as well as Europe, Australia and Far East (EAFE) companies.
The magazine also suggests lifestyle or target retirement funds. You may be able to mimic the philosophies of these funds on your own without having to pay the slightly higher fees that target retirement funds charge, but there is a theory that says one may forfeit small amounts to save oneself from headaches and stress. A family member is having me review her financial position; I will probably suggest she move funds invested in annuity products to a lifestyle fund that matches her plans for retirement. (At which point, I will remind her that I am not a professional.)
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Index funds are fine when indices are performing well, but they will not go well forever. I’d rather go with a mutual fund whose manager has a consistent record out of performing his or her benchmark.
Consider this information:
From Myths and Misconceptions About Indexing, the Vanguard Group.
The difficulty arises when:
a. very few active managers have a consistent record of beating their benchmark, and
b. there is no way to know who these “winning” active managers are ahead of time, and
c. active managers have additional and/or higher costs than a typical index fund — administrative & management costs + the tax costs of turnover when they trade in their portfolios
My conclusion: control what you can — your costs. And don’t spend a lot of time worrying about what you can’t control — the markets & the future.
Simplicity is definitely a key to building wealth. If you can simplify your lifestyle you can increase your investments. If you keep your investments simple you’re likely to make money off them just because there’s fewer places where complexity can take money out of your pocket.
A nice simple way to invest: find a good financial advisor
Complexity is the enemy of growth. If you can’t understand the investment and how it makes money, run like the wind. Keep it simple and cheap. Very, very few actually outsmart the market long term. It’s really very efficient.
Careful on the suggestions to family. One drop in principle and you’re never going to hear the end of it!
But complexity and what I consider desirable overdiversificationcan can put money in your pocket too. I never understand why there’s such a movement against overdiversification. It has advantages that I would rather mention in a future blogpost. Due to job changes, with my 401K, I have 16 funds in two 401K’s and an IRA, but I like to have around 12. There are so many diverse funds such as Real Estate, Sci/Tech, Emerging Mkts, Euro, Various Bonds. Each has it’s own characteristics.
The arguments against overdiversification, (assuming you have enough money in each to avoid fees), usually make little sense. I often hear overdiversified portfolios are bad because they then mimic an index and this comes from some of the same people who advocated buying an index fund.
I don’t trust putting all my money in one Target Year Fund because in the end, you’re not diversifying human judgment by using one fund manager. Putting it all in one fund is crazy if lots of money is at stake.