Index Funds Are Like Glazed Doughnuts – Boring!

by Hank Coleman

glazed-doughnutsI cannot stand glazed doughnuts.  They are so boring.  I try and surprise my family most weekends by buying them doughnuts at the local store before everyone wakes up.  I guess since I do it almost every weekend it is not really a surprise, but my little boys love it anyway.  I can’t stand glazed doughnuts though, but I have to buy them anyway.  Glazed are my wife’s favorites.  My little boys love chocolate covered doughnuts with sprinkles, and I usually bounce around between maple icing covered or cream filled chocolate doughnuts depending on how the mood strikes me.  I know what you are thinking, “Very healthy!”  Right!

Glazed Doughnuts.  Glazed doughnuts are like broad based stock index funds and should be a large portion of your retirement nest egg.  Glazed doughnuts and index funds definitely serve a purpose in our doughnut diets and investment portfolios alike.  Just like my family’s doughnut preferences, your family’s retirement investments need to be well diversified, and that is the beauty of index funds.  Index funds mirror the indices that they represent.  For example, an index that replicates the Standard & Poor 500 (S&P 500) is invested in the stocks of the largest five hundred companies in America.  The index covers a broad spectrum of industries, and you cannot ask for a better diversification of your investments.  Investing in one or two individual stocks put you at risk of losing a large portion of your money with the fluctuation of those companies.  If they have a bad day or quarter, your nest egg will take a beating.  But, if you are invested in one index fund that invests in five hundred companies on your behalf, then a bad day in a few stocks will be outweighed by other companies’ successes. 

Chocolate Cream Filled.  I like to think of chocolate cream filled doughnuts like actively managed mutual funds.  I love great mutual fund managers that consistently beat the stock market.  The problem is that they are few and far between, and they are very hard to find.  So, for my family, we allocate approximately only 30% of our retirement investments to actively managed mutual funds with excellent long term track records of beating their respective indexes.  One negative aspect of actively managed funds are their higher annual fees relative to index funds.  Index funds are like robots that mirror the index with little decision making and very little trading that keeps your costs lower.  Actively traded mutual funds are just that…active.  They trade in handfuls of stocks and create fees when they trade.  They also have to pay the salaries of those high profile stock pickers.

Chocolate Covered With Sprinkles.  Everyone needs a little excitement in their investment portfolios too.  We all should invest about 10% or so in interesting investments.  This is the portion of your nest egg that could be devoted to a precious metal mutual fund, real estate investing, commodities, currency trading, etc.  I have really enjoyed investing in peer-to-peer loans through Lending Club where I’m earning a 15% annual return on the loans I have lent through the site.  But, I wouldn’t bet the farm on any of these

Where Do Bonds & Cash Fit?  Great question!  I have no idea.  Maybe they are the milk that you wash it all down with.  I don’t like milk, but then again, I’m young.  So, that’s natural.  I don’t need milk in my life yet, and I do not need very many bonds either.  My own retirement and Social Security check are several decades away.  Milk, bonds, and a large pool of cash are for older investors who cannot stand the up and down roller coaster of the stock market because they are close to retirement or other goals. 

So, where does this leave us?  I still do not like glazed doughnuts, but I know that I need them in my life.  I need them to keep my wife happy, and a happy wife equals a happy life.  Just like glazed doughnuts, we need index funds in our lives too.  We need their diversification, low fees, market following, ease of investing, etc. in order to help us reach our investing and financial goals later in life.  While I’m still a huge fan of actively traded mutual funds and other exotic investments, I know that like chocolate cream filled doughnuts, they are good in moderation and to round out the diet.

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