Consistent and responsible investing is all about diversity. Unless you’re the kind of person who likes to live dangerously – very dangerously – you always want to make sure your investments have a level of variation that protects you from market volatility.
This is where index funds can be useful. Known for their inherent diversity, an index fund contains a mix of stocks and bonds that can largely be left alone to grow.
But is that inherent versatility really enough? Should investors who rely on index funds look into more deeply diversifying their accounts? Is there a point where diversification becomes redundant?
What’s An Index Fund?
Index funds are a group of mutual funds that are designed to track a specific index, like the S&P 500. Other popular index funds include the Russell 2000, which tracks the bottom 2,000 stocks in the Russell 3000 index, and the Vanguard Total Stock Market Index, which follows small, mid-cap and large-cap US stocks.
Index funds are popular because they often have low fees and offer a variety of stocks and bonds. Because they track an index passively, they don’t require the overhead and management that other funds do. One index fund can hold a few hundred or even a few thousand companies, so investors are fairly diversified when they choose an index.
Warren Buffett once famously won a bet against a hedge fund management firm to see if his index fund could beat their actively managed funds. Buffett won the bet, proving the value of index funds and calling into question the importance of micro-managing investments.
But despite their prominence (and Buffett’s approval), index funds are not a one-size-fits-all option. They’re perfect for the low-key investor who doesn’t mind a hands-off approach, but the question remains: do you need to diversify with index funds?
The Case for Diversification
Like many things, it’s not about the number of index funds you have – it’s about the quality. If you hold multiple index funds that invest in the same types of stocks and bonds, you’re not really increasing the diversification of your investments. But if one index fund focuses on US funds, adding an internationally-based fund will lessen your risk and broaden your prospects.
Many index funds focus on a particular market, such as the Vanguard Total International Stock Market Index fund, which tracks non US-based “developed and emerging markets.” According to Vanguard, “Long-term investors who want to add a diversified international equity position to their portfolio might want to consider this fund as an option.”
This is one example of an index fund that doesn’t give you the total diversification you’d want in a retirement portfolio. CFP John Angelo Flavin of Synergy Financial Management said asset allocation is one main reason to diversify your index funds.
Asset allocation involves balancing your investments across a variety of categories, including market capitalization, national or international, and value or growth stocks.
“Diversifying your index funds does make sense and is widespread across asset classes (i.e. an index fund for large cap U.S. value stocks, another for large cap U.S. growth stocks, another for developed countries other than the U.S., another for developing countries, etc.),” said CFP Erik Olson of Arete Wealth Management. “The slices can even be cut smaller and smaller for more specialized allocations.”
Olson said you can also choose to diversify even more by choosing multiple indices within the same asset class.
“Each index has its own rules for construction, and those rules don’t necessarily thrive in the same environment,” Olson said.
Still, there’s a limit to just how much diversification will really benefit you. It’s easy to go down a rabbit hole when diversifying, but that’s a waste of time after a certain point.
“You definitely don’t want to over do it,” Flavin said. “You don’t need to have five small cap funds in there.”
Your overall portfolio should have both US and international funds, small to large companies and both growth and income funds. As long as your index funds reflect that variety of investments, you should be properly diversified.
In the end, learning how to invest is all about how much time you want to spend researching. If choosing one index fund is all you have time for, that’s still better than not saving for retirement at all. But if you have the time and desire to look more closely at your portfolio, it will only benefit your nest egg.
Financial advisors are also capable of choosing a slew of diversified investments for you based on your retirement goals, risk tolerance and other factors that are important to your investment approach. If you handle it yourself, it may be overwhelming to decide which index is better and how many you need to hedge against market risk.