Individual investors love investing in a multitude of mutual funds. But, two funds are all you really need: a stock fund and a bond fund.
Too often, investors jump in and out of specialized mutual funds, chasing after last year’s or last month’s best performing sector.
This is partly caused by a fear of missing out on a hot stock. But, past performance is not a good indicator of future performance. Or, investors may have a hypothesis that a particular type of fund will do better in the future. These guesses are often wrong. Investors sometimes try to time the market, which also fails.
Asset Allocation is the Key to Better Performance
Most of the performance of an investment is due to the asset allocation, which is the mix between stocks and bonds. The individual investments do not matter as much.
Mutual funds with a higher percentage of stocks tend to have a greater return on investment, but also a greater risk of investment losses.
You can achieve any particular split between stocks and bonds by investing in just two funds, a stock fund and a bond fund.
If you want to decrease risk, you sell some of the investment in the stock fund and use the proceeds to invest more in the bond fund. If you want to increase returns, you sell some of the investment in the bond fund and use the proceeds to invest more in the stock fund.
Since stocks can appreciate faster than bonds, you may need to periodically rebalance your investment by selling stocks to maintain the desired mix of stocks and bonds. You should rebalance at least once a year.
Some people argue against rebalancing because it leads to capital gains. Instead, they prefer to use new contributions to return to the target asset allocation. However, since the investments are in a 529 plan, you don’t have to worry about tax efficiency.
You can substitute FDIC-insured certificates of deposit or high-yield savings accounts for the bond fund, if you wish. The purpose of the bond fund is to provide a low-risk return on investment.
Broad-Based Index Funds Work Best
Most mutual funds do not beat their benchmarks long-term. So, why not just invest directly in the benchmark, by using an index fund or ETF?
You don’t need to use a fund with more stocks than the S&P 500, like a total stock market index fund, since these funds all perform similarly. For example, the Vanguard Total Stock Market Index Fund ETF (VTI) increased by 24.2% in 2019, almost as much as the 25.3% increase in the S&P 500. Most of the performance of the S&P 500 and the total stock market index comes from the same set of about 70-80 stocks.
Passive index funds are better than active funds, since active management has higher fees. Minimizing costs is the keep to maximizing net returns. Active management rarely beats passively-managed funds when you take the sales charges and expense ratios into account.
Remember, the focus of a 529 plan is on long-term gains, which is where index funds excel.
Don’t Chase After Fads
Using a broad-based domestic stock fund, like the S&P 500, will help you avoid chasing after fads.
You do not need to invest in a Real Estate Investment Trust (REIT). If you own a home, you are already invested in real estate.
You also do not need to invest in foreign stocks. The U.S. stock market represents more than half of stock investment opportunities worldwide. Although foreign stocks can provide added diversification and smooth out volatility, they can also expose you to currency exchange rate risks, inflation rate risks, trade wars, lower liquidity, and political and economic disruption. After a few years of boosting investment returns by investing in foreign stocks, several 529 plans have suffered big performance drops due to high foreign stock exposure.
Limiting yourself to just two index funds will reduce the temptation to buy and sell funds to try to boost returns. It also helps that 529 plans are limited to just two investment changes per calendar year, which is enough for rebalancing.