A Lesson On Index Fund Investing

by Alan Lavine and Gail Liberman

Should you invest in an index fund that owns all the stocks that make up the S&P 500?

The S&P 500 is an index of the 500 largest, most profitable U.S. companies. The Vanguard 500 index fund is considered the lowest cost and most popular index fund, according to Morningstar Inc., Chicago. And this fund outperformed the vast majority of actively managed stock funds over the past 15 years.

Despite the S&P 500's track record, some financial advisers say you should not put all your money in an index fund. It's better to diversify stock fund holdings. David Marotta, president of Marotta Asset Management, Charlottesville, Va., says that the S&P 500 might be a core holding. Nevertheless, you also need to diversify stock fund holdings among large, medium and small company stocks as well as bonds. Different types of stocks and bonds perform in cycles. So when one type of stock is doing poorly, another stock or bond may be increasing in value.

The big problem with only investing in the S&P 500: You just own large company growth stocks. Also, an index fund stays fully invested. So when the market tumbles, you go right along with it.

Second, the index is market-weighted based on a stock's capitalization rate. The capitalization of a company is determined by multiplying the stock price times the number of shares that are outstanding for that company. That means that the stocks with the biggest market capitalization make up the biggest parts of the index.

The 10 largest capitalization companies make up about 23.4 percent of the S&P 500 index. When you invest $1,000 in the 500 index fund, you are not investing $2 in each of 500 companies. Rather, a full $234 of the $1,000 investment goes into the top 10 companies, which include General Electric, Microsoft, Exxon-Mobil, Pfizer, Citicorp, American International Group, Johnson & Johnson, Coca Cola, and Intel.

Due to these factors, S&P 500 index funds are aggressive and risky investments. By contrast, managed funds, he says, are much less risky and volatile. The reason: The fund managers can take defensive action in down markets to limit losses.

"Are we telling you not to invest in the S&P 500 Index mutual funds?" Marotta says. "No, only that you not invest all of your 401(k) or other monies in only that index. You need foreign stocks and inflation-hedged stocks and possibly some bonds." 

Alan Lavine and Gail Liberman are husband-wife personal finance columnists, journalists and authors. They are the authors of "The Complete Idiot's Guide to Making Money with Mutual Funds," published by Alpha Books. Their columns appear in newspapers throughout New England and the Southeast, as well as online. Their commentary on mutual funds and personal finance is carried by 200 radio stations nationwide every Sunday over Business News Network's Charles DeRose Financial Advisor Show.

More articles by Al and Gail can be found here.