A reader recently got in touch to ask about the merits of investing in index tracker funds versus individual stocks. I mean why not just bung everything into something like the Fidelity 500 Index Fund or the Vanguard 500 ? You’ll end up owning all the stocks I write about here, plus you don’t have to do any legwork. In the click of a button you get economic ownership over a massive chunk of corporate America.
It’s a good question, and for the most part I think low cost indexing represents the inevitable solution for most folks out there. I mean your average Joe doesn’t really care about why Coca-Cola is a better long-term bet than Alcoa. Why would he? He just wants to allocate his savings in the most efficient and convenient way possible. Setting up a portfolio of individual stocks just doesn’t appeal to a lot of people in that sense.
If you are inclined to go down to individual stock road, I would say the following: do not tinker with your portfolio too much. Pick the best stocks in terms of earnings quality, and hold them. Firstly, you’ll save a bunch on fees (and possibly taxes depending how you’ve arranged things), because you aren’t making trades left, right and center. Though it doesn’t seem like, they add up fast (and ultimately they represent lost compounding dollars).
Secondly there’s a fair amount of research out there that suggests turnover is just plain bad. That includes work done by Dr Jeremy Siegel who showed that a portfolio holding only the original S&P 500 constituents actually outperformed the index as a whole. For those going down the index route, it will all come down to minimizing costs (including taxes), which I’ll talk a bit about below.
Compounding’s Butterfly Effect
Consider the historical returns of Coca-Cola and PepsiCo. To nearly all intents and purposes these were identical investments in the latter part of the 20th Century. Indeed between 1957 and 2003 there was just a minuscule 0.01 percentage point difference in the average annual earnings per share rate of the two companies. (11.23% per annum for PepsiCo versus 11.22% for Coca-Cola in case you were wondering).
As it turned out, Coca-Cola actually ended up returning slightly more for investors over the period in question compared to PepsiCo. The former generated 16.02% per annum total returns versus 15.54% per annum for PepsiCo stock, and this assumes continual dividend reinvestment. (Note: I’m not saying one is a better investment than the other here, just pointing out the historical numbers).
Now you might be reading that and thinking that there isn’t much there. After all, 0.48% per annum sounds like a pretty small difference. But just consider the situation in absolute dollar terms for a moment. On a $1,000 initial investment that half a percentage point compounding away for just over fifty years would have been worth just over $160,000 to the Coca-Cola investor over the PepsiCo one.
With a bit of luck you see where I’m going with this. Saving as little as 0.1% per annum via a combination of choosing the lower cost “passive” funds and being as tax efficient as possible can really pay off down the line. Unfortunately some folks gloss over it because the difference is small initially.
For instance, imagine having a lump sum of $50,000 put into a S&P 500 tracker fund as a long-term investment. The difference between an annual fee of 0.05% and 0.15% is literally less than the cost of dinner in the first year. But remember, this is only true if you stop counting at that point. Imagine holding said fund for forty years or more. The total savings could be worth tens of thousands of dollars – nearly as much as the initial investment, assuming the fund generated annual returns of 10% per annum before fees.
The same argument applies to holding your funds in the most tax efficient way possible. Max out tax-free savings vehicles before investing in regular accounts. What sounds like a few dollars here and there has a habit of turing into a few thousand dollars (or even tens of thousands) down the line.
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