Use Paradox of Choice to Invest in Index Funds

By in Asset Allocation, Investing, Mind and Money, Mutual Funds | 3 comments

Paradox of Choice; Why More is Less

Do you feel overwhelmed?

Do you feel like you’re clawing ahead with your career and have no time left to learn how to invest?

Use the paradox of choice to simplify your index fund investing strategy.

How to Invest in Index Funds Effectively by Harnessing the Paradox of Choice

What is the Paradox of Choice?

Sheena Iyengar, a Columbia university professor and author of The Art of Choosing, published this historical choice experiment.

She set up a table with free samples of jam to visitors at a fancy market.

Group 1 chose from 6 varieties of jam.

Group 2 chose from 24 varieties of jam.

Then Iyengar calculated how many tasters from each group actually bought jam.

Her findings:

One third of Group 1 members subsequently bought jam. Those are the subjects that only had 6 varieties of jam from which to choose.

Only three percent from Group 2 ultimately bought  a jar of jam.

How did she explain this phenomenon?

As I discussed in Don’t Fall For Money Mind Tricks, when presented with too many choices, consumers become overwhelmed and paralyzed and have difficulty making a decision. As was shown in this example, the consumers with 24 jams, couldn’t make a decision and most bought none.

This paradox of choice also plays out in the investing world.

Reduce the Number of Index Fund Choices to Invest Better

Every time I see a new index mutual fund or index exchange traded fund, I become frustrated. The truth is, many new index funds, aren’t. According to Michael Pollock’s 2012 Wall Street Journal article, “Beware of Index funds That Aren’t”, some funds are attempting to grab part of the index fund investing dollars by manufacturing complex ETFs which combine active and index fund strategies. For example, the IQ Hedge Multi-Strategy Tracker tries to copy the returns of an index of hedge funds.

Do you know how ineffectual that investing approach is? First off, most hedge funds charge enormous fees. Secondly, hedge funds, in general trail traditional stock indexes. In fact, according to a bloomberg.com January 7, 2014 article by Kelly Bit, hedge funds trailed the S & P 500 Index (SPX) for the fifth year in a row.

How many funds do you need to create a viable index fund portfolio? In reality, you only need a few. Last week in “A Random Way to Invest“, I wrote about how Bret Arends posited that you could beat most hedge fund managers with one index fund which tracked the MSCI All Country World Equal Weight Index.

If you’re not ready to invest in just one index fund, let me explain why you don’t need a huge number of index funds in order to create an excellent investment portfolio.

How Many Stocks are Needed to Be Adequately Diversified?

 How many stocks are needed for diversification?

Notice how each of the graphs above, one for U.S. Stocks and the other for International Stocks show that after about 20 different stocks (from a variety of industries) each additional stock does little to reduce the portfolios volatility.

This means that there is little additional risk reduction benefit from holding hundreds of stocks.

Now, take this example and apply it to a diversified all world index fund such as the Vanguard Total World Stock Index fund (Investor Shares) (VTWSX), which is also available as an ETF. This single fund gives investors exposure to stocks in the U.S. and worldwide with and expense ratio of 0.30%.

With one index fund, investors can cover the entire world of stocks fairly well.

vtwsx geographic country diversification

 

In this exaggerated example, you could invest in one stock index mutual fund or etf such as the one above and be adequately diversified. VTWSX covers companies in the U.S., Europe, Pacific, Middle East, Europe, and Emerging Markets. Add a diversified bond fund and you have a decent portfolio.

How Would This 2 Fund Portfolio Have Performed Over the Last 5 Years?

As of 3/31/2014, the five year annual return of VTWSX was 17.98%.

The five year annual return of a diversified bond index fund, iShares Core US Aggregate Bond fund (AGG) was 4.85% (according to Morningstar.com June 16, 2014).

If you constructed a portfolio of  60% stocks versus 40% bonds using these two funds, your  five year annualized return would have been, 12.73%  [(.60 x .1798) + (.4 x .0485)].

It’s not a typo, with a two fund 60:40 percent  portfolio, you could have earned an annualized return of 12.73% over the past five years!

How Many Index Funds Do You Need to Choose?

For new investors as well as established investors, I’m not recommending a two fund investment portfolio.

But, what I’m suggesting is to narrow your scope of fund choices. There is so much noise in the world, and so many companies, advisors, and others vying for your money, that I’d like you to consider narrowing your investing focus. By eliminating the majority of index funds. Narrowing your choices to a few geographic regions, size companies, and asset types, you will not hurt your investment returns. Realistically, you might actually improve your investment returns.

Look at how these “Lazy Investment Portfolios” have performed and you decide how many funds you need. Use the paradox of choice to  simplify your personal and investing life. Narrow down your choices to simplify your investing life.

Action Step

Narrow your available fund choices, and you will simplify your life.

Consider reading these two books (they had a powerful impact on my lifestyle):

Essentialism by Greg McKeown

The Paradox of Choice; Why More is Less by Barry Schwartz

How complicated is your investment portfolio? Have you considered simplifying?

    3 Comments

  1. I’ve seen a lot of friends come to me to talk about their 401k at work. They either invested in just cash, not because they were scared of the stock market, but because they had no clue which funds to pick. The others ended up picking every single fund so they would be diversified.

    When I narrowed things down for them to just 3 funds, they looked at me like I was crazy. After explaining things to them, I saw the light bulb go on and they got it.

    Jon @ Money Smart Guides

    June 18, 2014

  2. I have been a proponent of a three fund portfolio (Vanguard Total U.S. stock market, Vanguard Total International sans US stock market, and Vanguard Total Bond market) for some time. In the current interest rate environment, I have exchanged the total bond market, with its average 5+ year maturity for a shorter duration bond index, but I still hold with the premise of a simple 3-fund low-cost passive index portfolio being a great choice for most people, that will beat almost all active funds after expenses.

    Bryce @ Save and Conquer

    June 19, 2014

  3. @Jon, It is so frustrating to me that the 401(K) options are so much more complex than they need to be. Your friends are lucky to have you.
    @Bryce-Agreed! How did you come upon this plan and avoided being swept up with the investing hype?

    Barbara Friedberg

    June 20, 2014

Post a Reply

Your email address will not be published. Required fields are marked *

You may use these HTML tags and attributes: <a href="" title=""> <abbr title=""> <acronym title=""> <b> <blockquote cite=""> <cite> <code> <del datetime=""> <em> <i> <q cite=""> <strike> <strong>

WP-SpamFree by Pole Position Marketing