Indexing is Great, But Don't Forget to Diversify

A real estate boom spurred by unreasonably low interest rates and the collapse of lending standards leads to a bubble, which bursts. Over leveraged financial firms face staggering losses and struggle to raise capital. The government tries desperately to to prop them up as losses mount.

Am I describing our current crisis, or Japan's 18 years ago? A number of experts, including Morgan Stanley's Stephen S. Roach, have compared today's credit mess with the bursting of Japan's real estate bubble in the 1990s. If the comparison is apt, investors in broad stock market indexes like the S&P 500 may be in for a tough decade.

Here is how Japan's stock market fared after the bubble burst in 1990:

An investor putting a monthly amount in the Nikkei 225 before 2003 would be much better off keeping that money in a bank account instead.

There's a reasonable chance that a decade from now the S&P 500's chart will look similar. The last ten years haven't been so great either. Investing a monthly amount into the S&P 500 from March 1998 through August 2008 would give you an annualized return of around 1%.

A diversified portfolio, which, in addition to US stocks, includes bonds, REITs, international stocks, commodities and other asset classes would have done better. Putting equal monthly amounts into index funds tracking the S&P 500, bonds, international stocks, and REITs would garner an annualized return of around 4%. Certainly, 4% is nothing to brag about. But those three percentage points make a sizable difference. Investing $1,000 a month into the S&P 500 over the last decade would result in a portfolio worth a little over $132,000 today. Investing $1,000 a month split evenly between the four different asset classes would be worth a little less than $178,000 today.

As retail investors (and most mutual fund managers) are terrible at picking individual stocks and market timing, index investing is the way to go. Just remember, don't put everything in one asset class. If we have a lost decade like Japan's, a diversified portfolio should offset losses in the US stock market.

That's one of the ideas behind my ETF portfolio. In its first two weeks, it's lagging the S&P a bit. Come back every once in a while to see how it does.

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