A Better Way?

The simplest approach to diversifying your stock market investments is to invest in one index fund that represents the entire stock market. The problem with having your entire common stock portfolio invested in one “entire stock market” index fund is that eventually, at some backyard barbecue, you will cross paths with a Wall Streeter who, upon learning that your entire common stock holdings consists of only one mutual fund, will argue that you are way under diversified and will pay for that mistake the next time the stock market drops.

Just smile and say, “Please pass the potato salad.”

Excerpt from my first book, The Coffeehouse Investor - How to Build Wealth, Ignore Wall Street and Get On With Your Life.

Is there a better way to diversify your common stock investments beyond one “total stock market” index fund by adding value, small, and international dimensions to your portfolio?

In my opinion, there is, and here’s why.

Intuitively, all things being equal, the less you pay for a dollar earned, the better off you are. In Wall Street terms, it is calculated via the Price to Earnings (P/E) ratio.

But wait! What happens if company A is growing its earnings twice as fast as company B? Does company A warrant a higher stock price & P/E ratio?

Maybe yes, maybe no. At what point do investors bid up company A to a level that its earnings of tomorrow can’t keep up with its inflated price of today?

Are you better off owning company A (large-cap stocks) or company B (value stocks)? How about a little of both?

Over the 96-year period ending 2023, value has outperformed growth 78% of the time during rolling, 10-year overlapping periods.*

This same research shows that small-cap stocks beat large-cap stocks 68% of the time.

There will be periods when value and small stocks underperform, as they have over the past ten years. Nevertheless, this data implies that it might be worth owning a little value and small to complement your large-cap holdings.

Combine this historical data with Vanguard’s forward-looking projections, forecasting domestic large-cap stocks to be its worst performing dimension in the decade ahead, and that is reason enough for me to diversify beyond a total stock market fund.

As a Coffeehouse Investor, I have no idea which market dimension will outperform in the years ahead.

That is why I include all of them in my portfolio.

Looking for Guidance?

The financial world environment looks very different nowadays. Investors can’t afford to continue in the current markets using outdated investment strategies. Connect with me on a complimentary strategy call and let’s review your investment approach and long-term plan for building wealth.

*Dimensional Fund Advisors Quick Takes - May 2024