News & Commentary

Beginning a share portfolio from scratch 23 Apr 10

No matter your age, you probably have clear memories of the first shares you ever bought – and about how those shares fared on the market.

Sadly, many fledgling investors would put their meager savings on a single stock, perhaps only to watch its market price shrink. 

Personal finance writer David Randall, in his latest Forbes Magazine column, provides a broad overview of why traditional index funds and Exchange Traded Funds (ETFs) can be extremely useful for new investors, and all investors for that matter. And he emphasises their attributes for an investor seeking a low-cost, widely diversified portfolio.

Given the column’s target audience of first-time investors, the language is straightforward and easy to read.

“Owning such a broad index of stocks [in ETFs or traditional index funds] will protect you from the ups and downs of individual companies,” Randall writes, “and increase the odds that your investment will grow over the long run.

“Some of them [stocks in the index] may fall,” he adds. In fact, some will inevitably fall. “But you’ll also be buying the up-and-comers that nobody knows about yet – probably even the next Google.”

Then Randall asks and then answers a highly pertinent question for would-be investors. “Does individual stock-picking sound more exciting? Probably, but consider the drawbacks.

“First, you can make a bad bet and spend $20 on a company that may soon be worth $1. Second, the act of buying and selling repeatedly makes a cash cow for brokerage companies.

“You’ll need to pick a steady stream of winners just to break even – and even professional fund managers have a hard time doing that.”

Reading Randall’s column prompted Smart Investing to reread an article, Why Indexing Should be the Portfolio’s Core, written last year by Jeffrey Molitor, US-based head of Vanguard International Institutional Asset Management.

It’s fascinating that the arguments in favour of index investing are the same whether for small investors and large institutional investors.

“For any investor – whether an individual or committee in charge of a large pool of assets – building an investment portfolio that can meet short and long-term objectives is a challenge,” Molitor writes.

“Our experience and research indicate,” he adds, “that a portfolio’s core should be in indexed assets. Many investors would do fine investing exclusively in index portfolios …” But Molitor recognises that some investors using index funds also would want the opportunity through active management to try to add above-market returns after accounting for all costs.

“Those who do [use active managed investments in addition to index investments] should be aware of the additional challenges and commitments along that path,” he cautions.

In short, Molitor’s paper includes these key points, which Smart Investing has often discussed in the past:

• Asset allocation determines the majority of a diversified portfolio’s risk and return.
• Only a minority of active fund managers add value after their costs are taken into account.
• Investors who want to include active funds in their portfolios need an above-average ability to select those managers.

Molitor says that even institutional investors with “exceptional skill in selecting active managers” would benefit from indexing a sizeable portion of their portfolios.

Interesting, he emphasises that although Vanguard created in 1976 the first index fund for individual investors, its roots were in active funds and about half of its worldwide assets under management today are actively managed.

As Molitor says: “Our perspective stems from a unique background.”

* Written by Robin Bowerman, Head of Retail at Vanguard Investments Australia.
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