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In yesterday's post I said that investing in the right basket of 20 or so individual stocks could give you the same performance and diversification as owning an S&P Index fund but without the fees. Many of you thought that was a bad idea. Allow me to acknowledge those criticisms and suggest a modification to the plan that addresses them.

Criticism 1: Exchange Traded Funds (ETFs) mimic the S&P 500 (see ticker symbol SPY), and their fees are trivial, so forget the basket of 20 stocks and invest that way. (Full disclosure: That's mostly how I invest in stocks.)

Answer: If you had $350,000 in stocks, your annual fee for an ETF would be in the range of $1,000 a year. That is small compared to a managed fund which might charge you $5,000 per year, but it is still real money. If you could save $1,000 per year and give up nothing, you would do it.

Criticism 2: Most of the historical gains of the S&P 500 came from a handful of hot stocks, such as Dell. Your basket of 20 stocks has a good chance of missing the hot stocks that make all the difference.

Answer: Good point. Let's modify my plan to say that each time you put money into the market you pick a company from the S&P 500 that meets two criteria:

The stock has one of the highest ratings of the stocks you don't already own, according to a source with no conflict of interest, such as Charles Schwab. This increases your odds of getting a hot stock, since those would be rated high.


The stock improves your diversification compared to the stocks you already own.
 

Criticism 3: If you buy stocks every month, as you earn money to invest, the transaction fees can get expensive.

Answer: That's true, so don't buy stocks every month. Do it once or twice a year. Each stock you buy or sell will cost about $9 once. Or if you have lots of patience and discipline, invest only when the market drops from its high by ten or twenty percent.

Criticism 4: The S&P 500 changes composition over time, weeding out the weaker companies in a crude way. Your basket of 20 stocks wouldn't get that benefit.

Answer: After you own twenty stocks, sell off the lowest rated stock and replace it each time you add money to your investment, once or twice a year. This prunes the laggard stocks in a crude way similar to how an ETF would rebalance its position.

The most important element of this revised investment plan involves ignoring the advice of pundits and columnists, and especially ignoring your own gut feelings about stocks.

I hope it is obvious that you shouldn't get your financial advice from cartoonists. And feel free to tell me why this modified approach is defective. That's always the point of anything you see on this blog.

 
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Oct 29, 2008
Wow - some of my comments from yesterday got mentioned - cool.

However, I'm not convinced they've been completely addressed. In particular, if you only buy stocks once or twice a year, you would avoid the "death by a thousand paper cuts" of bi-weekly or bi-monthly stock buying fees. But this means you've got some of that money sitting inactive for 6 months to a year. Obviously, you'd keep it in an interest-generating account (money market based on Treasury bonds or such) - but you're likely missing at least 2-4% of the money you'd gather from an S&P 500 account (assuming an average rate of return). This might not be a huge amount - but it's non-trivial.

So, the question becomes - is saving $800 (or whatever) a year by not paying management fees greater than this opportunity cost fees of buying individual stocks. An individual investor would need to calculate all this based on their individual case - if your iinvestment spending tends to come in "big chunks" (say, due to a large yearly bonus, or maybe making a SEP fund contribution or such), perhaps the yearly or biyearly scheme makes more sense. If you're investing roughly equally from each paycheck, it probably wouldn't.
 
 
 
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