For many tasks in life, we have the ability to outsource to another person or group of people, or to get the job done ourselves and insource the task. This choice occurs on a daily basis. So many tasks are an obvious ‘duh’ to insource, such as tying our shoes in the morning. Others are more dubious, such as mowing the lawn. Depending on your temperament, you might prefer to do this task yourself or you might rather hire a guy to come in every other Saturday and clean things up for you. On the other end of the spectrum, you have a task such as tuck-pointing a brick house. Sure, you could spend time to learn the skills yourself, but over 95% of people are going to choose the “hire the right man for the job” option.
Well, where does the task of investing and money management fall in this spectrum? It is clear that some folks prefer hiring financial advisors, while others like to manage their own investments. Since a minority of actively managed mutual funds actually beat the market, some sage advice is to simply buy the market via a low-cost, low-turnover index fund, instead of fiddling around with picking out individual investments.
Today I was pondering the differences in investment styles between owning a large cross-section of the American economy via an S&P 500 index fund versus just putting together a collection of common stock from most of those same companies. Does it really behoove the lay investor to hand money over to the index fund broker more than to own securities in the most ‘pure’ way possible, that is, through direct stock ownership? Throughout the following example we’ll look at the pros and cons of each approach.
Let’s say in 2004 you suddenly had a large windfall. Maybe your geographic area just experienced a huge increase in home values, and you decided to sell your personal residence. Or maybe your rich uncle died, and left you an inheritance. In any event, assume you woke up one day and had a lump sum of $100,000.
You, being such a smart individual, knew that you shouldn’t blow all this money, but rather, invest it somehow. You wanted to make a decent return but didn’t want to get risky. Also, you knew that there are many investing strategies out there but you didn’t have time to mess around with all that and do research on specific companies and various types of investments.
Scenario 1: S&P 500 Index Fund
From just brief research you find that sticking your money into an S&P 500 index fund should follow the market, which has returned an average of 10% compounded annually over the past century.
Opening an account with Vanguard, you select the low cost S&P 500 index fund, VFIAX. Since you invested over $10,000 initially, you get a lower price for the expense ratio that you pay for the fund each year. In this case, the fee is a rock bottom 0.05% (this is really good).
After the account is setup, and the money is transferred from your bank you go about your life and don’t touch the money. Assume that all dividends from the fund were reinvested. Today, ten years later, what would you find?
You’d see that your account has grown at 7.76% on average throughout the years. Your account balance is now $211,929. Not such a bad deal for a single fund with low fees. Speaking of fees, you would have paid a little over $650 over the ten-year period to Vanguard (I multiplied the expense ratio by the end of year balance for each year and added up the numbers).
Keep in mind, if the trend continues and your investments grow at the same rate they have been, you’ll be paying around $100 per year beginning this year with the cost of management increasing at the same rate that the investments grow (assuming Vanguard keeps the expense ratio the same).
Scenario 2: Direct Stock Ownership
Now let’s say that instead of putting the $100,000 into the S&P 500 index fund, instead you split your money up evenly among the top twenty companies in the S&P 500 by market cap. Note that these top twenty positions account for 31% of VFIAX’s total assets (in 2004), so you’re buying shares of the biggest and baddest companies that make up the S&P 500. These are the companies you buy positions in:
Bank of America
Johnson & Johnson
Proctor & Gamble
You go online to a brokerage company like Charles Schwab or TD Ameritrade and set up an account. Each group of shares you buy for each company costs $8, so after splitting the money up and paying the commissions, you’ve spent a total of $160 and have your money split between shares of twenty companies that are valued at $4,992 total for each position. In your brokerage account you make sure that the “Reinvest Dividends” box is checked for everything. You log off, ignore the account and go about your life. Ten years later, what do you find?
Every company you invested in performed differently, but in aggregate, your portfolio compounded at a rate of 6.77%. Okay, so you trailed the market by 1%. But in the end you still compounded your wealth through the Great Recession by almost 7%, ending up with $192,187 worth of stock in your account. In addition, you haven’t spent a dime in management fees over the past 10 years because you held the stock directly. Here is the data that I compiled showing how your portfolio did:
Wow, look at that. Citigroup got smacked around and AIG got really smacked around. On the flipside, Chevron posted exceptional growth and Altria’s returns should make you want to want to shout, “hallelujah!” to whichever God you believe in. For the most part, the big winners covered up the few big losers.
Ok, this is all fine and dandy, but let’s be honest, you left $20,000 on the table by picking 20 individual stocks instead of picking the index fund. Now, before the Bogleheads pop up shouting “See! See! Index funds are obviously the way to go, duh…” let’s talk about another piece of the puzzle that we must consider – dividends.
Those top 20 companies you picked happen to be hefty dividend payers. Even AIG, which was been sufficiently battered and bruised by the hit it took in the recession, currently pays a small dividend. The only exception here is Dell, which went private in 2013. The shareholders were paid a special final dividend and that was it. The rest of the companies, however, still sport some decent dividend yields. The overall yield of the portfolio right now in 2013 (not yield on cost, but the current yield if you bought shares today) is 3.25%. Compare this to the 1.81% that VFIAX is currently yielding. If you are at all concerned with the present and future income of your investments, direct ownership trumps mutual funds because the cash gets paid directly to you as a shareholder.
Additionally, there is another very important aspect that needs to be considered: control. Now, we all know that we cannot control what CEOs and the board of directors at companies do or not do. Heck, even Warren Buffet only has so much influence at Coca-Cola even though his son is currently on the board and his company, Berkshire Hathaway, owns a significant minority stake.
However, one thing to note is that with an index fund or other type of mutual fund, buy, sell, and hold decisions are made for you. This is why the Vanguard S&P 500 Index Fund no longer holds the same amount of shares in the same companies now as it did in 2004. This particular fund is designed to match the S&P 500, so naturally Apple and Google are near the top fund holdings as of this writing. Wal-Mart is no longer a top 20 holding. What if I did some research and really believed that Wal-Mart has significant growth opportunities and I wanted to hold onto it (not saying this is necessarily true, but just as an example)? I’d look to directly owned shares, so I can make the decision to buy, sell, or hold myself.
OK, so let’s look at the results of the two scenarios again:
Scenario 1: Your portfolio is now worth $211,929. Before taxes the dividends received from this portfolio would be around $3,835 annually, with this number rising as companies increase their dividends. It will cost about $100 annually to maintain the portfolio, with this number rising as the value of your portfolio increases. You have no control over the investments in the fund.
Scenario 2: Your portfolio is now worth $192,187. Before taxes the dividends received from this portfolio would be around $6,246 annually, with this number rising as companies increase their dividends. It will cost nothing to maintain this portfolio. You have complete control over the investments in the portfolio.
In either case, you will have made money and done respectably for yourself. In both cases, you also remained reasonably diversified. Some folks will tilt toward the index fund option because it is completely hands off and does a good job. I personally tilt the other way because I am willing to do the research on a company in order to make a good investment (well, I admit I am a novice but I am learning as I go!). Additionally, I want direct access to the income that comes from stocks that pay dividends, and the ability to allocate each position as I see fit. Each course of action has its own sets of problems and prospects – your job is to be as rational as possible and decide what is best for you.