Tuesday, February 18, 2014

How to Create Your Own Personal "Index Fund"

Amidst the universe that encompasses financial planning, what seems to perplex and puzzle people the most?  The casual answer usually is “the stock market” or “how to properly and safely invest.”  With financial planning, it is much easier to wrap our minds around proper insurance coverages, paying off the mortgage sooner rather than later, and understanding healthy debt versus corrosive consumer credit debt, compared with diving into the often murky waters of stock investing.   

When it comes to retirement planning with an advisor, we are often told to max out our 401(k), or other type of IRA.  The planning process typically concludes with the individual getting excited about putting together a mutual fund portfolio that will bring him or her the proverbial pot of gold at the end of the retirement rainbow.  This is all fine and wonderful, and certainly possible.  But, there is another young tree that you can plant, which if cared for properly, and with surprisingly minimal attention, could be one of the tallest and strongest trees among your different nest egg strategies.  It entails the selection of individual stocks in your brokerage account.  You may have to talk with your bank or financial advisor on how to properly open an IRA in which you can select and purchase individual stock within a discount brokerage, but it is easy to do.  The hard part is knowing how to select good companies yourself or with minimal help.  In this article, I’ll highlight one strategy of doing it yourself, versus relying solely on mutual funds, which is the way most individuals and couples invest.  
               
First off, the advantages of owning a mutual fund involve the diversification and ability to have a professional fund manager watch over the fund, and ultimately, your money.  If you go this route, it’s best to choose a no-load fund company such as T. Rowe Price or Vanguard.  The easiest way possible is to choose an index fund that mimics the S&P 500 or the Dow.  This is not a bad way to invest, albeit at a basic level.  It works, provided you are several years away from retirement, and can handle the periodic swings of the market.   

Now the disadvantages to mutual fund ownership are the yearly management fees (typically .5 to 2%) which, however small, with eat into your returns year after year.  Over a lifetime, it will add up.  In addition, most mutual funds are too diversified, meaning they have to own dozens if not hundreds of stocks.  Again, not a huge problem, but it will be hard for most mutual funds to consistently beat the averages year after year.  Yes, some funds will outperform.  However, every year, the business news reports how a majority of funds did not outperform the market.

How does a person with no financial or accounting background select a portfolio, which will take little more than an hour per month, to monitor?  One way is to purchase the DOW Jones Industrial Average.  For example, purchase every stock (currently 30 stocks) in the DOW in equal dollar amounts, and then hold onto them.  This amounts to an index fund that you have created yourself, without the management fees to eat into your returns.  The benefit of using the DOW is that it represents some of the best companies in America in which to invest.  Many of those companies also pay dividends. Even better, many of them increase the dividend yearly.   For example, Proctor and Gamble has increased its dividend for more than 55 consecutive years.  By mimicking the Dow, you have eliminated the necessity of having to start from scratch researching companies. 

As for the downsides of the above approach, first off, make sure (as with any mutual fund) you have a long term time horizon that is several years into the future. If you are less than five years from retirement, you may want to seek the advice of a professional regarding how to put together a conservative portfolio.  If you have no interest at all in looking at your portfolio, at least monthly, then you may be better off using mutual funds.  Third, if you are going to mimic the DOW and purchase all thirty stocks, then it is best to have approximately $1,000 invested per company, for a total of $30,000, so your brokerage commissions are not too large a percentage of your purchase. , If you have $15,000, then choose fifteen stocks in the DOW that pay dividends with a history of increasing the dividend over time.  The dividend history is often located in the investor relation section of the company website.  It may be under the heading of “stock information” within the investor relations tab.  If you have $10,000, then invest in ten DOW stocks with a history of annual dividend increases.  If you have less than $10,000 to invest, best to stick with a mutual fund or funds for diversification, as the commissions in purchasing stocks may be too costly for this approach.  

The above approach should require very little buying or selling, as you are mimicking the DOW.  If one stock becomes too large a percentage of the total portfolio, for your comfort level, then sell some shares and redistribute the proceeds among the other names in your portfolio for a more equitable weighting.  If you invest in this manner, you will closely, although not exactly, be following the DOW in a way similar to a mutual fund.  

For the above reasons, if you have the time, and the interest, consider putting together your own “index fund.” You will save on the management fees, closely mirror the DOW’s returns, and likely have some fun in the process.  However, if you have no time to devote to this approach, rest assured that purchasing an index fund with a  reputable no load mutual fund company is a great way to go.  Best of luck in whichever journey you decide to embark upon. 

By Ken McLemore, licensed CPA in the State of California

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