How many index funds should an investor own? There is no single answer that fits each investor. Each person is in different circumstances with different investment goals, times of investment, and risk tolerance. Index funds share specific characteristics – low management fees and multiple company securities – but differ in their investment objectives, perspectives on different market sectors, and the risk they assume in their holdings. Consequently, one investor might be comfortable with a single index fund; another invests in several funds, each with a unique composition and objective.
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Balancing Risk and Reward
The investment logic underlying an index fund is to earn the highest return with the least risk. Owning stocks of a diverse group of companies in different industries, each of which is affected differently in specific economic conditions, produces an average return for the portfolio companies. In most cases, some stocks will go down while others go up, offsetting the gains and losses of each.
Even in periods of economic stress and falling stock prices, some companies thrive, add earnings, and reach new highs in stock price. During the period 1929-1932, the Dow Jones Industrial Average lost almost 90% of its value. During the same period, the securities of United States Steel Corporation, American Tobacco Company, Standard Oil Co. of New Jersey, and Paramount Publix Corporation made new historic highs.
Diversification is the primary risk management tool used by insurance companies and investment managers.
A property insurance company with a single client will quickly go out of business if the insured’s home burns. The same result happens to an investment manager who invests his capital in a single company. Insurers cover their risk by having thousands of homeowners who pay premiums and never collect a penny. The investment manager buys tens of different companies, some of which will prosper when others suffer. This effect is due to the law of large numbers or “pooling:” the number of entities in a pool subject to risk decreases the likelihood that the portfolio will fail.
“It’s not how much money you make, but how much money you keep, how hard it works for you, and how many generations you keep it for.” – Robert Kiyosaki
Types of Investment Risks
Since the 1950s, investors have generally followed the modern portfolio strategy, a theory about constructing a portfolio to maximize returns based on the investor’s selected level of risk assumed. The theory presumes that those investors willing to accept greater risks seek to (1) optimize the returns consistent with the level of risk or (2) reduce risk consistent with the expected return. A stock portfolio is subject to
- Systematic risk. Also called “undiversifiable” or “market“ risk, systematic risk affects the whole market, not just a single company or industry. It is unpredictable and impossible to avoid completely. A recent example would be the effects of the Covid-19 pandemic that affected markets and economies worldwide.
Systematic risk is measured by a stock’s sensitivity or fund returns to the general market returns (β or Beta). A β of 1.0 means that the two move together in concert. A β of 1.2 means the stock or fund is more volatile than the index or general market; if the general market moves 20%, the stock moves 24%. A β of less than 1.0 means that the stock is less sensitive to the market. If the stock has a β of .5 and the market falls 10%, the stock price would fall 5%. - Unsystematic risk. It is also called “specific” or “diversifiable” risk. It is the risk that affects a single company or industry, such as a strike, government regulations, or a natural disaster. Unsystematic risks are managed through diversification so that one company’s catastrophe does not threaten the viability of the portfolio.
Diversification Within an Index Fund
Diversification is more than just numbers; variety also matters. Concentrating investments in a single geography or industry exposes the portfolio to the risk that a natural disaster, a new technology, or a change in political fortunes will wipe out your investment. Holding a portfolio of stocks or bonds alone exposes you to market and inflation risks. Remember that the greater the number of assets combined with the broadest variety is theoretically safer than any other portfolio:
- Number. A fund with ten stocks has more risks than a fund with 100 positions. If a small portfolio company goes under, you have a minimum 10% loss; if one company in the 100-position portfolio folds, you have a minimum 1% loss.
- Variety. A fund with 40% of its investments in a single industry will lose a greater amount of value if the industry suffers than a fund that limits a single sector to 10% of its holdings.
All index funds are diversified, each holding a portfolio of different securities. Some are broad-based, with hundreds of holdings in multiple industries. The Capital Asset Pricing Model (CAP-M) tells us that the optimum equity portfolio is the whole market, generating the highest return per unit of risk.
How much diversification is enough? Most experts claim that 20-30 positions in a portfolio are the optimum level of diversification. Additional diversification reduces potential returns to a greater amount than the reduction of risk obtained.
Broad market funds trade potential gains for less risk. For example, a risk-averse, long-term investor can find maximum safety in a broad-based index fund such as the Vanguard Total Stock Market Index (VTSMX). The Index represents approximately 100% of the investable U.S. companies – a cross-section of market capitalizations – that trade on the New York Stock Exchange and NASDAQ. A more focused yet fully diversified portfolio is available in the Schwab S&P 500 Index Fund (SWPPX) that tracks the total return of the S&P 500® Index. For many investors, a single broad-based index fund satisfies their investment needs with low cost and minimal sleepless nights.
Sector Investing
Many fund managers claim that picking the right stock is less important than choosing the right sector or industry. Different economic sectors and industries do well in different economic environments such as falling or rising interest rates, booms or recessions, investor optimism or pessimism. A sector index fund invests in multiple companies within a single industry or sector. In return for incurring more risks than a broad-based index fund, investors increase their potential returns by concentration.
Selecting the right industry is more critical and more manageable than choosing the right company.
Investing in several sector index funds further insulates an investor from loss by spreading the risk, especially by selecting sectors that benefit from different market environments. Index investors can choose sector funds, including technology, healthcare, energy, precious metals, and transportation. Other specialized index funds limit themselves to specific global regions or socially responsible investments.
An example of a very high-risk, high-return sector fund is the ARK Disruptive Innovation fund. The fund focuses solely on “companies with a disruptive innovation that significantly lowers costs to increase demand.”
For those who are comfortable with more risk, sector investing is a good strategy. Rather than attempting to identify the best company, those who prefer to invest in specific sectors of the economy should own three to five index funds in unrelated industries.
Final Thoughts
The decision to own one broad-based fund or several sector funds is a matter of personal preference, especially one’s willingness to assume financial risks. When investing, it is essential to keep in mind that risk and return have a positive relationship: The more risk one takes, the greater should be the possibility of increased profits.