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Welcome to the latest edition of the DailyKos Investment Club!  Previous entries have been on The Basics and Evaluating Risk at Disneyland.  I strongly enourage others to compose their own Investment Club entries, since I have one more I'm planning for next week, then this series will sink or swim with the contributions from other Kos denizens.  This entry is about index funds!  As investments, they rock for alot of reasons, although they leave alot to be desired from a progressive standpoint.  More below the fold...

30 years ago, all mutual funds were actively managed.  That means they were run by people who were always researching the market, finding things to buy and things to sell.  It sounds like a good idea, except for two things: the fund managers didn't produce very good performance from their funds, and they charged about a 2% annual overhead for their trouble.  Most actively managed funds failed (and continue to fail) to match the performance of the S&P 500 Index, which is widely considered the standard benchmark for performance. Along came a smart dude named John Vogel, who invented the index fund.  The idea is simple: invest in the 500 biggest companies in the market (the S&P 500) in proportion to the size of the company.  It's very simple, and you don't need a high-priced manager siphoning off the profits.  The Vanguard Index 500 (VFINX) was born, tracking the S&P 500 with great precision and low expenses.

Since then, a zillion index funds have come out to track big companies, small companies, medium companies, all companies, etc., but they share some really nice features for investors:

  • Good return on investment: An index fund matching the S&P 500 beats up to 90% of actively-managed funds in the long-term.

  • Low expenses:  Expensive funds don't yield any better performance than cheap ones, so you always want to minimize expenses.  That's why you should never buy a loaded fund (where you pay up front to buy a fund), and you want to have a low expense ratio.  Index funds don't require much management, and don't buy and sell shares very much, so there is very low overhead.

  • Diversification:  Unless you buy an index fund which specializes in a certain industry, you are getting a broad swath of companies.  If one industry tanks (like the Internet, for example), you take a hit but you haven't lost everything.  See the Disneyland entry of the investment club for more details on what I mean.  A broad-based index fund like Vanguard's Index 500 is like the Big Thunder Mountain Railroad: some ups and downs, but pretty tame over all.

  • Taxes:  There are three basic types of investment accounts: tax free (e.g. Roth IRA), where you never have to pay taxes on what your investments earn; tax deferred (e.g. standard IRA), where you don't have to pay taxes until you take your money out of your account; and taxable, where you have to pay each year on what you earn in dividends and capital gains.  For the first two types of accounts, it doesn't really matter how tax efficient your investments are because the money you would pay each year in taxes gets reinvested regardless.  If you have a taxable account, however, you have to pay capital gains when a mutual fund sells stocks for more than it paid for them.  What you pay in taxes you can't keep investing.  Index funds work almost like a tax deferred account because they buy and sell very little, so the money you would have payed in taxes this year is still in your investment.

There is one big drawback to index funds for progressives: by default you are investing in some slimy companies.  If you own the Vanguard Index 500, here are the top ten companies you are invested in:

  1. Intel
  2. IBM
  3. Bank of America
  4. Wal-Mart
  5. Johnson & Johnson
  6. Pfizer
  7. Citigroup
  8. Microsoft
  9. General Electric
  10. ExxonMobil

Ewww!  Big oil, a nuclear / defense contractor, and Wal-Mart!  As I outlined in The Basics, there are multiple approaches to progressive investing.  One way to do it is just hold your nose, maximize your profits, and then donate your ill-gotten gains to The Nature Conservancy, The Rocky Mountain Institute, etc.  

The other alternative is socially responsible investing.  The definition of socially responsible can vary greatly, but any socially responsible investment will probably rule out the worst offenders.  Socially responsible mutual funds have the same problems as regular mutual funds: actively managed funds have high expenses, which lower your returns.  There is such a thing as a socially responsible index fund, however.  Vanguard has a fund (VCSIX) which tracks something called the Calvert Social Index  (CSI).  If you compare the social index fund with the plain one, you find some key differences.  The top ten for the CSI fund excludes ExxonMobil, GE, Citigroup, and Wal-Mart!  Of course, the return on your investment has been lower for the socially responsible fund, so there is a tradeoff.  Here is an article I googled up which discusses social index funds.  Just be sure to check the expense ratio before you buy, since some index funds have higher expenses than others.

DISCLAIMER: I don't receive any money for anything I mention, although I do own VFINX.  Remember, this advice is worth what you paid for it - get lots of opinions to help you develop your own!  In particular, I offer no advice as to whether now is a good time to purchase an index fund or anything else, since I don't really know.  I'm in it for the long-term.

Originally posted to CA Pol Junkie on Fri May 06, 2005 at 02:55 PM PDT.

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Comment Preferences

  •  next week (4.00)
    Next week, I'll post about how to profit from Republican fiscal and economic mismanagement!  

    Other than that, the investment club will need posts from others to keep going.  Just put "Investment Club" in the title and the top of the post itself so search will find it.  Link to the previous couple posts to help people find older entries.

  •  Thank you.... (none)
    I've been wanting a socially responsible index fund.  Are there any others?

    Hijack their frames! Cheap, easy, effective.

    by chriscol on Fri May 06, 2005 at 02:57:54 PM PDT

    •  There are... (none)
      Here is an article which discusses a few.  From the research I've done on socially responsible investing, it seems like SRI has relatively high expenses, which are a big no-no for me.  The Vanguard one I mentioned has an expense ratio of 0.25%, which is quite good.  The fund (and index) is just about 5 years old, though, so it doesn't have much of a track record.
  •  Thanks for this diary (none)
    Right now, my main priority is to pay off my credit card debt, but I've been reading various financial books and various message boards and have read great things about Vanguard. Their website is really easy to use and I recently encouraged my father who recently retired to roll over his 401K to Vanguard's Lifestrategy Conservative Growth fund. Once I have sufficient funds of my own, I'm going to start my Roth IRA at Vanguard, probably with their Lifecycle 2045 fund and once I have $10,000 in the IRA (it's going to take a while), maybe diversify with the Total International Stock Index.

    I've found that Morningstar's message board for Vanguard devotees to be really helpful in providing investment advice. Here's the link:

    http://www.diehards.org/

    I've just lurked over there and haven't joined the discussions, but the members of the board are pretty good about answering investment questions from new/inexperienced investors.

    Another reason why I like Vanguard is b/c I recently found out that the Founder of Vanguard supported John Kerry for president, despite being a life-long Republican. I found this over at Andrew Tobias' site:

    John Bogle Knows Value

    What does it tell you when Warren Buffett, Robert Rubin and John Bogle - perhaps the three best-respected money guys in the country - all favor Kerry?  Buffett is the son of a conservative Republican Nebraska congressman.  His common sense - and skill at sizing up CEOs - are legend.  Rubin, of course, was Bill Clinton's Treasury Secretary.  Bogle, a Republican, founded the exceptionally investor-friendly Vanguard family of funds.  

    From yesterday's Philadelphia Inquirer:

    "There's a fine line between boldness and recklessness," cautions Bogle, a Republican who intends to vote for John Kerry. Boldness must be tempered by foresight and deliberation, Bogle says.  "We can't have a country run by philosophers . . . But a good leader is thoughtful. He seeks the counsel of others and is capable of introspection. Before making a decision, he walks around it and tries to see it from all sides.  . . . Commitment is admirable in a leader . . . but there's no virtue in committing yourself to the wrong idea. Staying the course just to stay the course is folly that invites tragedy."

    http://www.andrewtobias.com/newcolumns/041027.html

    Also, good point about investing in socially responsible mutual funds. If Pres. Bush's private accounts for SS ever does get off the ground, we might want to create a wedge issue b/w the Christian fundamentalists and the corporate crowd w/in the Republican party. Pres. Bush has said that the private accounts would be invested in index funds based on the Thrift Savings Program. One of the funds in TSP is indexed to the S&P 500. How would the Christian right like to know that their money from social security is being used to finance Disney or Microsoft, Proctor & Gamble or any of the other corporations which they have found so objectionable and called for boycotts against in the past?

    Anyway, thanks for continuing the investment club education series . . .

    •  Vanguard (none)
      I'm a Vanguard devotee because the expense ratios on their funds are very low.  I own three of their funds.

      Paying off your credit card debt is an excellent idea - it's worth tightening your belt to get that monkey off your back.

      •  Yes, the low expense ratio (none)
        was what convinced my dad to invest at Vanguard. He looked at T. Rowe Price pretty closely, got a consultation with one of TRP's reps, but decided to go with Vanguard instead. He noticed that T. Rowe Price gave pretty good service, their website had interesting video links and they even sent him a cd-rom with an asset allocation calculator. But he realized (after a little subtle convincing from me) that the expense ratio for Vanguard's mutual fund would be .24 or something like that and T. Rowe Price's expense ratio for a comparable fund would be about .6-.7. Since he and my mom are now on a fixed income, the expenses were a big factor for him in choosing Vanguard.

        Now, I'm trying to convince him to set up a cd ladder. We'll see how that goes . . . .

        Thanks for the encouragement about paying off my credit card debt. I've paid off almost $6,000 since December. That's pretty much all my tax return and whatever extra that I could scrounge up after paying my bills. Now I'm just trying to figure out whether I should devote more money into the Roth or whether I should start paying some principle on my 20 year private student loan after I get done paying off my credit card debt. I know interest rates are going to be going up and I'm really concerned about how much interest I'm going to have to start paying once Greenspan starts really raising the interest rates. The interest of fed student loan are limited to 8.5% (I think), but my private student loan has a variable interest rate and doesn't have those limits. So I'm going to be royally screwed if Greenspan or his successor has to raise interest rates really high!! :shudder:

        Word to people that are entering college, don't take out the full amount of the school loans that the financial aid offers. It's tempting to have all that "free" money, when you're in college/graduate school. It's not that fun trying to pay all of it back . . . .

  •  Diversification? (none)
    CA Junkie, or anyone else can jump on it.  This is a good basic topic we should be sure is covered:

    What is Diversification?  What are some good and bad examples of "being diversified."  This topic is completely missing from the conversation but should not be ignored.  Sector funds and index funds should be juxtaposed in such a discussion.

    In particular relevance to this diary, it is important to consider exactly what market segment that index fund represents.  

    Check out this article on some other index funds.

    In particular, note that if you have shares of the S&P 500, you could diversify by looking at the Russell 2000 Index.  You could also diversify further by looking at MidCap 400 Index.  Even if you have looked at each of these three, you have still not exposed yourself to international market funds, which can be another great lever toward a diversified portfolio.

    There are lots of ways to mix and match.  Keep hunting.

    •  you're seriously diverse! (none)
      As far as America stocks are concerned, I think most would consider and S&P 500 index fund, or a MidCap fund, or a Russell 2000 fund to be quite well diversified, since you won't have an excessive amount in any sector.  However, you raise a very good point in regard to international funds.  There is benefit to being invested outside the United States in case of economic crisis here at home.  I'll touch on that in my post next week (regarding profiting from GOP economic and fiscal mismanagement), but I encourage you to put together your own Investment Club diary since you seem to have thoughts on the matter.
  •  One of the major trends... (none)
    Consumers are buying more from companies that are good to their workers or who are socially responsible.  Hence, one of the reasons why Wal-Mart is trying to be a smiley face on their labor situation.

    Consumers are also very loyal to those companies.  

    Progressive stocks could be a good buy, because the trends are favorable to more people shopping at progressive companies.

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