Buy-and-hold strategy for index funds

Factual Questions
1

I’m 25, and trying to save for retirement. I figure time is on my side and I can take advantage of compounding interest and ride out recessions and all that.

I’m really into the idea of just buying shares and holding on to them until I need to withdraw money in 40 years to buy dentures or whatever.

So I put some money into an index fund a few years ago and it’s been pretty great seeing my money grow. But that’s just because the stock market’s been going up recently. What happens if it should fall? Wouldn’t I just lose all the gains I made? I remember back in 2009 when the market was down to 7,000 and reading how people’s 401Ks and savings got totally shafted. This seems very precarious and compounding interest doesn’t seem to factor into this at all.

Actually, is there any way I can take advantage of compounding interest? The only things I can think of are like bonds, savings accounts, and CDs, all of which have terrible rates of return.

So my question is, is raising the percentage of bonds in my portfolio as time goes by the only way to counteract the risk of index funds? Is the buy-and-hold investing strategy only for optimists? I’m guessing a lot of the retirees who had held on wished they had sold before the market fell. How can I avoid that fate when it’s time for me to retire?

2

Ideally, you want to both buy-and-hold and also dollar-cost average your share purchases. That way, when the market is down, you’ll acquire more shares. I recommend doing this by weekly or monthly contributions to the index fund.

3

First thing is to learn about investing. The Motley Fool website (www.motleyfool.com) is a decent place to start (or at least was the last time I looked at it way back when). It sounds like you are well on your way on this score, but learning some of the finer points would be good.

And here’s one of the finer points: as you get older, your risk profile changes. So you’d move some of your money from equities into bonds (or other lower risk investments). You’re young now, so you can recover from a drop, but you can’t recover when you’re older, so you take less risk then.

4

It’s all about asset allocation. The basic idea is that you change how you invest based on your age and how close you are to retirement.

Historically, the stock market has been the best long term investment, particularly for periods of over 20 years, but as you have seen, in any given shorter term period, it’s possible to lose money. So what you want to do is to invest the money that you won’t need for 20 years in the stock market, and put the rest in other less volatile investments. Many financial advisory sites have information about how to allocate your income. Here’s some information from Fidelity.

You can also purchase a targeted fund, which automatically reallocates your money based on your retirement date. Some people don’t like these because a fund manager is picking the selections, and they are not as broad as an index fund, but they are an option if you don’t want to have to work too hard on your portfolio. The ultimate idea is that right now, when you are young, you can pour your money into the market, but as you get older and closer to retirement, you take your gains and put them into safer investments. By the time you retire, you should have a good nest egg built up in assets that aren’t subject to economic downturns.

5

It’s not the only way, but yes, decreasing risk by moving from stocks (fairly volatile, i.e. high risk but high RoR) to bonds (low risk but low RoR) is a very common strategy. My 401(k) in particular all goes into a “target retirement date” fund, which states that it will invest in a high percentage of stocks today (I’d probably retire around 2050-2055), and move to a progressively higher percentage of bonds as my retirement date rolls around, to prevent the scenario where I’m getting ready to retire right when the market hits a huge dip which wipes a huge amount of value out of the stock market (and me right along with it). 40 years is a damn long time to ride out all those dips.

6

Yes! Many sites give you an option for “Dividend Reinvestment.” So say, if you own, the S&P 500 Index (SPY), if your share of SPY pays out a .78 per share dividend, the broker automatically re-buys you .78 worth of SPY.

Sounds as if you may already be doing this. Is your Index Fund just depositing money into a cash account?

Bonds are usually what people move into to lower risk. Keep in mind though, Index Funds are ALREADY considered much less risky than owning individual stocks since you become instantly diversified. Depending on which index you own you could also look into foreign indexes or, if you own a Dow 30 or something, a broader domestic fund.

But as BorgHunter points out, your horizon is SO FAR in the future, today’s monthly market swings will end up meaning nearly nothing when you take it out. I know it’s often hard when you’re just starting out to see your hard earned money go kaput, but just keep in mind how long you have to let it grow when things turn around.

No. In fact many very reputable economists believe it’s the BEST strategy for people without a boatload of time, capital, and knowledge to contribute to their investments. Warren Buffet says, “Avoid debt. Buy Index Funds.”

Studies have shown that while many funds beat the market, nearly none of them can do so over time after deducting management fees. Therefore, you are likely best to buy a non-managed Index fund with low management fees.

There are also Target Funds where a manager will automatically allocate the fund’s resources based on projected retirement date. I believe management fees would be a bit more expensive for these, but they’re also likely the utmost in “set it and forget it” retirement investing.

7

A broad based mutual fund or exchange traded fund is the way to go for the long haul. Low expenses or none. S&P 500 based funds are the predominate vehicle. Historically a more narrow fund that focuses on the higher dividend paying portion of the S&P does better. As always, YMMV.

8

I keep meaning to plop something in an index fund whenever this comes up and I never get around to it. Can anybody suggest a good one with a low, low minimum?

9

I recommend the Vanguard index funds, although the minimum initial investment is $3,000. I don’t know if that’s more than you’re prepared to invest.

10

Vanguard.

11

I would also recommend Vanguard for having some of the (if not the) lowest fees in the industry, but the minimal outlay is going to be $3K for the funds, and $10K if you want the “admiral” shares (with even lower expense ratios. The Admiral shares minimum used to be $100K up until about a year ago). The bulk of my investments are with them. Even their retirement funds which automatically reallocate your investments from stocks to bonds as you get older are extremely low fee (like under 0.20%).

12

Retirement funding made easy with very little time involved:

Get a trading account (Like through Schwab) or whatever.

Buy a no-load growth mutual fund that has a 4 or 5 star rating. Everytime you have money to throw at it, throw it into this fund.

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Once you have about $50,000…

Familiarize with asset classes. You probably have chosen a mutual fund that is large or medium sized growth. This means the mutual fund looks for growth companies that are on the larger side.

There are 3 others to look at right now. Small growth, Large value and small value. The difference between growth and value is that growth funds look for companies that have a good potential to rise through price through growth. Value looks for undervalued companies that will soon jump up to their ‘true’ value. In reality, there probably isn’t a huge difference.

Start a mutual fund in one of the other 3 categories. If you had initially chosen Large Growth…choose Small Value. Let this build until you have $50,000.

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Once you have at least $100,000 (at least $50,000 in 2 different funds)…do the same for the other 2.

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Once you are well North of $200,000 with $50,000 at least in each type above…time to look overseas. The 2 biggies here are Europe and Asia. Do the same thing above with these 2. Pick one and start putting money in it. There are many mutual funds out there that specialize in Europe and Asia.

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Once you have $50,000 in each of the 6 above you should be well North of $300K. Also, you should be much older. Now is the time to start looking at other things…but the above will get you far.

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I know the above sounds simplistic. People will come at you and talk about this and that and the other thing. All that is fine…but, seriously, if you follow the above you are 90% of the way there.

13

One issue to asset allocation and buy-and-hold investing is to periodically rebalance the portfolio.

Let’s say that you decide the perfect balance for you right now is 80% stock and 20% bonds and those are the only two asset classes we’re going to worry about.

In a good market like this year, your stock is growing faster than your bonds. By the end of the year, you might be at 85% stock and 15% bonds. At this point, you want to sell some stock and buy some bonds so you’re back to your target 80/20.

In a bad market like 2008, your stock tanks and you find that you’re now at 60% stock and 40% bonds. Sell some bonds and buy stock to get back to 80/20.

The beauty of this system is:

  1. you’re always returning the portfolio to the risk profile you’ve selected.
  2. you’re always selling high and buying low.
  3. you’re not making panicky, emotional decisions.

Another advantage is that it’s easily adjustable so that novices can learn over time. Let’s say you become a more savvy investor next year and you realize that all stocks are not equal. There’s large, mid and small. And growth and value. And international. You can redesign your target portfolio to include as many categories as you want. Instead of a simple 80% stock and 20% bonds, you might be 40% large cap, 20% small cap, 20% international, 20% bonds.

The biggest challenge is coming up with the right allocation in the first place, but there are many free guides out there with sample portfolios.

14

Thanks for all the info everyone; I appreciate it and find it reassuring.

I have a follow-up question specifically about Vanguard. I have a mutual funds account with them for my index fund. I’m probably missing something here, cause it seems inefficient, but if I wanted to buy bonds, would I have to get a separate broker-based account? Are there mutual funds specifically for just bonds I can purchase with my existing account?

15

Vanguard has plenty of different bond funds available. Go to your Vanguard account, click on Research Funds and Stocks > View All Funds by Asset Class, and select “bonds” in the Asset Class category.

Also, Vanguard has bond ETFs, so you could look in that category for bonds, as well.

16

Something else is make sure you are putting enough money away for retirement.

While I understand at 25 lots of people new to the job market are hungrily eyeing being able to spend real money for the first time, at that age you should really put 12% of your gross pay each pay period into retirement.

The thing about that is, the worse you do at that now the worse it gets later on.

If you put 12% away now, then at age 55 you’ll still be putting 12% away and you’ll be fine and dandy.

If you put too little in now, you could be faced with having to put 20% or more of gross into retirement each pay period at age 40+, and just because you’re older there is no guarantee you’ll be able to easily stomach that at 40.

17

Also make sure that if your employer has any special investment plans you are taking advantage of them. Many will have a 401(k) or similar plan (457 for many public sector employees), the downside is many of these plans have a limited fund selection but most majors funds are usually represented (Vanguard, Fidelity, T.Rowe Price, Barron’s etc.)

If your employer is giving any sort of % match you always want to cap out that before you think of putting anything into a separate IRA account you open with a broker like Ameritrade or Scottrade.

18

You’re young, understanding about investing is one of the best things you can possibly do.

Always remember: all the advice, market pundits, investment banks, etc are skewed to buy buy buy. That’s the way the industry makes money. So things like a “hold” recommendation on a stock really means what a total fucking piece of shit that I wouldn’t foist off on my worst enemy. Understanding that is very key.

Second is the great myth of dollar averaging. Shesh, whoever came up with that makes PT Barnum look like a rookie. Look, there is absolutely nothing wrong with putting money for an investment into the bank every month. Then, reading the broad economic indicators, either buy stock or sit on the money.

Because wall street only cares about churning your account on a short term basis (see above) no one will ever tell you this is a good time to sit out and wait for the crash. It’s not that hard to see the broad economic trends and then bide your time. For example, if you had sold everything and put your money in the bank a year before Lehman’s went bust and bought Vanguard a year after, you’d have a shit eating grin on your face. If you had dollar averaged over the same time period, your return would be on the tepid side of lukewarm.

Dollar averaging is for retail suckers. And at 25 you can decide if you want to be a retail sucker your whole life or if you want to figure out how the Wall Street game is played.

Any “advisor” that gives you the dollar averaging spiel about a fund is an ignorant shyster.

BTW, I spent 7 years on the institutional sales floor in Tokyo and Hong Kong. So my two cents only (and no offense to those that think dollar averaging is the best thing since sliced bread but I think you’re investment strategy is that of a sucker).

19

You should also check out Morningstar.com. These two sites will give you most of what you need to start.

20

And read www.bloomberg.com headlines every day. It’s what the entire investment banking industry reads. Great way to slowly learn what people in the industry care about and look at from a news perspective.