by Archie M. Richards, Jr., CFP^®
January 1, 2001

Are you bleeding profusely because you concentrated too heavily in tech stocks when they looked so promising in 1999 and early-2000?

For many years in the future, I expect Internet and other tech stocks to perform well. But no matter what the market leaders may be, do not, for the rest of your natural life, concentrate your money among the so-called leaders. If you sink your entire future into just those stocks, the market will deflate that future. It might take a while to sneak up behind you, but eventually it'll take you down.

Limit your investments in individual securities to only 10 percent of your total portfolio. If the total isn't substantial, the 10-percent share won't enable you to achieve proper diversity. Better, then, to avoid individual stocks altogether.

For U.S. stocks, use an index fund that tracks the Russell 3000 Index. Calculated by the Frank Russell Company, the Russell 3000 is an index of the performance of the 3,000 largest U.S. companies, constituting 98 percent of the value of investible U.S. equities.

From January 1 to December 22, 2000, the Russell 3000 Index was down only 8.8 percent. Were you down this little?

In the ten years ending September 30, 2000, the Index appreciated 19.6 percent per year. Did you gain that much?

iShares offers a mutual fund that tracks the Russell 3000 Index. To save transaction costs, it doesn't buy all of the 3,000 stocks. But it buys enough of them to track the Index closely. As U.S. stocks go, so goes this fund.

The fund is no-load, with no sales charges. It is always invested fully in stocks. Since the stocks composing the Index change infrequently (usually when a company is acquired), the fund trades infrequently. Transaction costs and tax consequences are therefore insignificant. The management fee and expenses are only 0.20 percent per year. Total costs, including taxes, are almost certainly less than 0.9 percent. (When such a fund is sold, years hence, the taxes could be substantial. But all along the way, money not previously paid in taxes compounds for your benefit.)

John Bogle, founder of Vanguard and now head of the Bogle Financial Markets Research Center, analyzed 384 equity mutual funds for the fifteen years from 1984 to 1999. Here are the average costs he found:

• Front-end commissions: 0.5 percent per year.

• Opportunity costs, because of the funds holding about 7 percent of their assets in cash, earning lower rates than on stocks: 0.6 percent per year.

• Commissions and spreads from high turnover rates: 0.7 percent per year.

• Federal and state taxes on dividends and capital gains, mostly because of the rapid turnover: about 2.7 percent per year. (401(k) Plans and Traditional IRAs are temporarily tax free, but the government eventually claims its due.)

• Management fees and operating expenses: 1.2 percent per year.

• Total average costs: 5.7 percent per year.

Before these costs, the returns of the 384 funds Bogle analyzed approximately equaled that of the market, namely, 16.9 percent per year. But after the above costs, the after-tax returns to shareholders were only 11.2 percent per year (16.9 less 5.7).

Assume that you place $10,000 in a non-index fund that nets 11.2 percent a year, after tax, as above. In fifteen years, you'd have $49,200.

Alternatively, you place $10,000 in an index fund that nets 16 percent a year, after tax (16.9-percent market returns, less 0.9-percent assumed costs). In fifteen years, you'd have $92,600 - 88 percent more than the $49,200 above.

Why stop with just the U.S. stock market? There's a whole wide world out there. The more diversification you have, the safer you are. Will the rest of the world grow faster than the United States? I hope so. It beats foreign aid and provides bigger markets for Americans to sell to. Invest half of your money in the U.S. and one-sixth in each of the Vanguard index funds for Europe, the Pacific, and Emerging Markets.

Never mind trying to guess between "growth" and "value." Use the index funds that cover both. Maximum diversity and minimum costs: You just can't beat 'em.