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Experts tell us that a small number of carefully selected stocks - fewer than twenty - would nearly mimic the S&P 500 in terms of diversification and performance. That means you could buy just those stocks and never have to pay a fee for fund management.

Avoiding fees is a huge deal when it comes to lifetime earnings. Managed mutual funds have substantial annual fees. Even an index fund has a management fee. So does a SPDR. If you buy your twenty stocks and just sit on them, you avoid all of the fees while enjoying the same performance and diversification as managed index funds.

It wouldn't be hard for experts to tell you which stocks to buy, and how much of each, in order to mimic the S&P 500. But you will have a hard time finding that sort of information because no expert has an incentive to produce it. Perhaps an author of some sort has produced it, but I haven't seen it.

Obviously everyone can't buy the same twenty stocks because they would quickly become overpriced. But there are many combinations of stocks that would give you the same performance and diversification as the S&P 500. All you need is a computer program that randomly spits out a different basket of stocks for each investor, so the buying gets spread around.

For the lack of that simple information, and the false believe that managed funds have some magic advantage, investors spend billions each year. Arguably, that makes it the most valuable information in the world.
 
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Nov 2, 2008
It's funny that there are quite a few comments knocking the "obviousness" of the post. I recall reading a paper where two economists obtained information on 40,000 brokerage accounts. Their study revealed that something like (it's been a while) 75% of the accounts held 4 or fewer stocks and 90% of the accounts underperformed their baseline index portfolio.

I guess we're all above average around here.


 
 
Oct 29, 2008
Scott says : "Experts tell us that a small number of carefully selected stocks - fewer than twenty - would nearly mimic the S&P 500 in terms of diversification and performance. "

The number 20 comes from a statistical analysis comparing individual stock price volatility to overall market price volatility. If I remember correctly, it takes 20 to eliminate 99% of the volatility and it takes 12 to eliminate 95% of it.

"Beta", which is shown for stocks on most finance sites, is the relationship of that stock's price volatility to the overall market volatility. A beta of 2 means that if the average daily price swing of the market is 1%, the average for that stock is 2%. Beta is calculated using price swings over time, and does not mean this happens every day.

Whether one uses 20 or 12 stocks, what matters is that the selected stocks are not significantly correlated. For example, picking GM and Ford would not count as 2 since their stock prices are strongly correlated. Neither would picking one of the car manufacturers and a car parts manufacturer. What makes finding the 20 (or 12) difficult is finding stocks that do not correlate. Ideally, you would want to find stocks with inverse correlation.

But doing all the work necessary to achieve this type of diversification will only save you the relatively small fee that comes with buying an index fund. A lot of work for mediocre return.

"the most valuable information in the world"? Hardly.
 
 
Oct 29, 2008
The incremental diversification decreases by every stock you add the portfolio. After 20 stocks its meaningless.

The number of stocks in a portfolio has no effect in its performance, only to diversification.

No one can consistently predict the performance of individual stocks.

So, its irrelevant which stocks you select for your portfolio. Just pick 20 randomly and it will work.
 
 
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Oct 29, 2008
Rebalancing your portfolio sounds like solid advice. It means you buy the more of the stocks that are low-priced. That works pritty well, assuming that this particular firm will stay in business. If it is going bankrupt however, the stocprice will plummet and you will buy more of it, because the price is low and you are rebalancing. Now the firm goes bankrupt. Whoops, there goes the money.

I agree with phb. Concentration is the key. Pick a few firms that you trust will stay in business. But most of all, use your common sense.
 
 
Oct 29, 2008
This kind of thinking -- "gee, I bet I could pick stocks just as well as those guys, if someone just gave me a good list of stocks to buy" -- is what has fueled an enormous market for investing newsletters, in which stock-pickers who are supposedly smarter than the rest of us share their picks and their strategies.

And that, in turn, created a market for meta-newsletters to pick the stock-pickers, like Mark Hulbert's !$%*!$%*!$%* !$%*!$%*!$%*!$%*!$%*!$%*!$%*!$%*! let's not forget the American Association of Individual Investors (http://www.AAII.com) which provides getting-started help for generating that "computer program that spits out different baskets of stocks".

It is possible for individual managers to beat the market. But, unfortunately, picking the people who will beat the market is almost as hard as picking the stocks themselves. "Past performance does not indicate future gains." In the end, what looks on the surface like a simple problem of consistently picking twenty diversified stocks is actually an enormous problem. If you enjoy that sort of thing, it might be worth the effort . . . but in the meantime, I would stick with the index funds.

Also, don't underestimate the "honey-our-lost-our-shirts-in-the-market" effect. The reason so many people willingly turn over their finances to "expert" managers is they don't want to accept the blame for making a bad decision. The thrill of beating the market doesn't always outweigh the terror of possibly losing everything . . . and it being all your fault.
 
 
Oct 28, 2008
The most valuable information in the world? What about next week's winning lottery numbers?
 
 
Oct 28, 2008
"The Most Valuable Information in the World"? Christ died for your sins. He stands knocking at the door, he's not going to force his way in, but if you invite him in, He will come in and change your life.
 
 
+3 Rank Up Rank Down
Oct 28, 2008
Anyone notice that when the Dow loses 400 points its front page headlines, but today the dow is up 700 points & CNN doesn't even show it on its home page.
 
 
Oct 28, 2008
If you could replicate the performance of the S&P 500 (or entire stock market) with a small number of stocks, it might avoid some fees. Howevere, you'd still be stuck with having to rebalance frequently, making numerous small purchases when doing dollar-cost-averaging as you deposit 10% of each paycheck (or whatever), and over time you'd need to move companies in & out of this portfolio as their fortunes change - just like the DOW needs to every now and then. Overall, seems more trouble than it's worth - unless you're planning on making a one-time investment or you get 30-60 "completely free" stock trades a month.
 
 
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Oct 28, 2008
Sorry to double post - but, please don't mix risk and volatility with return. No such thing as "high reward" without "high risk" and all of you touting Vanguard or 7% mattress funds or your genius broker who demonstrated his mastery of the "efficient frontier" need to ask yourself what you want to accomplish...is it return or safety? Can't have it both ways, sorry. It is just that type of thinking that created our entire banking/financial crisis.
 
 
Oct 28, 2008
Are you sure SPDR's have management fees? You buy them just like regular stocks so I'm not sure how an additional fee could be in there. As pointed out above, buying index funds even at big firms like the Vanguard has a negligible management fee (0.15%?) a tiny of fraction of what you'd pay for a mutual fund. I haven't bought these for a while, but when I did something like that would be worth it just in convenience to get the whole S&P500 instead of 20 different stocks.

Brian
StartBreakingFree.com
 
 
-1 Rank Up Rank Down
Oct 28, 2008
Well, coming from a country where savings accounts give you 7% a year after taxes, I simply cannot understand this stock market thing. So you put your money in stocks… and hope they’ll go up???

I still have some brain formatting to do before figuring that one out. I haven’t heard an argument about the advantages of the stock market that makes me believe it beats putting the money under my mattress :-)

Honestly, it all depends on when you invest. If you put your money in the stock market on 1960, you’d have pretty much the same by 1975. And it’s pretty likely that we are reaching another market stall of 15 years. So in this sense, pulverizing your stocks doesn’t really make sense – mattress it is. Putting all of them in the same stock… well, maybe if you buy Sleep Country’s stocks… :-)

I know I’ll change my mind, it’s not like there’s an option… but right now, I’m just glad my money IS under my mattress, hehehehe
 
 
+1 Rank Up Rank Down
Oct 28, 2008
Scott - I have blathered on here before about the myth of diversification and you have just made my case, partly! Despite the popular myth that "proper diversification" will provide better than market returns, it is all bunk! Real returns happen in only one way, CONCENTRATION. All other strategies are nothing more than risk management techniques, including the much lauded "Modern Portfolio Theory." So, the most "valuable" or most expensive information in the world is the knowledge of what single stock to buy. All of you index fund buyers and diversification flag holders are flat wrong. Tell me, how did your well diversified portfolio perform over the last month? Thought so...
 
 
Oct 28, 2008
Wow, this was pretty much a pointless article. Find a good mutual fund like CGM's Focus Fund (cgmfx) managed by Ken Heebner. Or invest in the Proshares Ultra S&P 500 (sso). If you think the market will go up over time the sso gets you double the return on a daily basis. Also since it works as a doubler for daily fluctuations, a long term uptrend gets you more than double due to a compound interest factor.
 
 
Oct 28, 2008
It's true that buying fifteen to twenty stocks gives you reasonable diversification from one perspective; but at the same time, it also puts all your eggs in a single basket. You are investing all your money in a single asset class - US stocks. You reduce your risk, but still are tied to the volatility of one of the most volatile asset classes in existence.

At the same time, you also need to look at balancing that portfolio. If 10% of your total investment is in stock 'A' based on your evaluation of your portfolio, then it should stay 10%, within reason. But how do you decide when to rebalance? If it goes up in price to where it now is 15% of your portfolio, then you should sell off 5% to rebalance - however, if you do that, you end up with either regular income on which you must pay taxes, or you get capital gains taxes (which Obama will soon raise if he gets elected) that eat into your gains far more than paying a fee-based advisor would. So being totally invested in one asset class can hurt you more than help you.

Also, you should have hedges to reduce risk. What's a hedge? Take, for example, gold. Gold tends to have large swings that go counter to things like inflation and the market. It can provide a buffer against volatility; but you shouldn't own gold, per se, but rather gold funds.

Then, there are other asset classes - foreign stocks, bonds, real estate, etc. Investing requires understanding of these classes and how they counter-balance each other. This takes a lot of learning and a lot of time, to both understand what you're doing and then to take the time to re-balance when necessary. Each time you do, you risk having a tax burden, as well as paying fees to brokers, etc. when you sell and buy.

So for my bucks, I'll pay a fee-based person to manage all this for me. All the executed trades are free; tax liability is greatly reduced (until I sell some of the assets) .

If you want to do it yourself, there are web sites that will guide you through some questions about your goals, risk tolerance and other factors, and then recommend a diversified portfolio for you made up of a split of many asset classes along with recommendations on hedges. It will then be up to you to execute those trades, do your due diligence and watch your portfolio to see if it goes out of balance, accepting the brokerage fees and tax liability. Or, you can pay someone between 1-2% of your balance to do it for you. Your choice.

One web site that gives advice with no obligation is www.ricedelman.com. You can run through the above type analysis completely anonymously, and get their recommendations. Then, if you have any questions, you can call them and they'll answer the questions, again with no obligation.

I'd suggest you at least go to a fee-based advisor who offers this kind of thing to at least give you a baseline to work from in your investment strategy. If you don't, you're working from ignorance and will react emotionally. You'll end up missing opportunities while gambling on risky fliers; you'll buy high and sell low because emotions will override your limited knowledge. Again, your choice - but with the dearth of economic education in this country, most of our citizens know virtually nothing about money. It's up to you to do it yourself. Good luck.
 
 
Oct 28, 2008
You can get lower management fees than an index fund by buying (through a discount broker) an exchange-traded-fund (ETF) that holds the same stocks as the index fund, but you'll pay brokerage commissions. You should look at how much you plan to invest initially and each time you add to your investment and do the math for yourself. In general, the more you invest and the longer you hold it, the better deal an ETF is compared to an index fund.
 
 
Oct 28, 2008
Quick question. I've recently changed my 401k investments to mostly index funds. (15% bond, 50% S&P 500 index, 10 S&P 400 Mid cap, 10% S&P 600 Small Cap, and 25% Div International) I am in my early 30s and want a riskier investment strategy. I basically chose all the index funds and/or the funds with the lowest management costs. So the questions is should I rebalance my account now (when the market is low) or wait a year or so to rebalance. I have noticed that my balance has gotten out of whack from my last choices.

 
 
Oct 28, 2008
I disagree with your opinion about index funds for a simple reason: I'm not sure about Dow etc., but at least for the German Dax, I know that occasionally, stocks are removed, and new stocks are added (since the Dax is supposed to contain Germany's largest 30 companys). Overall all I think it's not the more successful stocks that get removed. Thus, you have as simple (but senseful) kind of management within an index fund, but a very low management fee.

On the other hand, since index funds have been becoming very popular in Germany lately, I have also asked myself if this could lead to the Dax stocks being overpriced because of the addtional demand...

I ´should have bought Volkswagen :-)
 
 
Oct 28, 2008
Wow, it is amazing that information is so incredibly vague can be so valuable. That rates right up there with "To win the lottery, all you have to do is pick the right numbers".
 
 
Oct 28, 2008
Scott - the S&P 500 is a capital-weighted index (stocks affect the index proportional to their market capitalization, or price*total shares outstanding), as opposed to the Dow Jones 30 (which is a price-weighted index - they add up the price of 30 stocks and divide by 30, and apply an adjustment factor). Thus, as I've read,, ~15 stocks make up 25% of the movement of the S&P 500, ~25 stocks make up 50% of the movement of the S & P 500,. So you could get a close approximation with just 25 stocks. (or put another way, when index investing was all the rage, most of the benefit went to 25 or so stocks that got very overpriced). Not sure it's good investing though.
 
 
 
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