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BULLS & BEARS: Passive investors need to consider diversification

January 17, 2005

We think the argument for diversification rests with a decision to choose "passive" investing over "active" investing.

So-called active investment management is found in mutual funds where managers are actively making decisions to buy or sell stocks and bonds. It also describes the investor who builds and manages a portfolio of individual securities.

Passive management describes index investing. It amounts to an investor's deciding he wants exposure to the markets but does not want to be bothered with selecting and monitoring his investments. It is an "I'll take what the market gives me" approach. In an index fund, the securities in the portfolio are constructed to mimic a chosen market index.

Previously, we suggested that for investors who possess the proper temperament and who are willing to commit the time and effort to identify a handful of attractive securities, a broadly diversified portfolio is unnecessary. A concentrated or "focused" approach, using a handful of carefully selected securities, has the opportunity to provide above-average results.

After all, for an active investment strategy to outperform the general market averages, it cannot invest like a market index.

That noted, investors should assemble a diversified portfolio if they neither have the time nor the inclination to carry out the process of monitoring a focused investment portfolio. For the investor who chooses to go this route, there is one factor paramount to the success of this program: low cost.

Note that a portfolio of several actively managed mutual funds may, in sum, hold stakes in several hundred securities. The investment costs on such a portfolio may well prohibit returns in excess of, say, the Standard & Poor's 500 index.

Index, or passive investing, can be obtained at a relatively low cost because there is no effort to analyze or monitor the securities held. A number of investment vehicles are available today that give an investor exposure to broad areas of the stock and bond markets.

They come in the form of index mutual funds, IShares and other exchange-traded funds. Wide diversification can be obtained by simply purchasing shares in one of these vehicles, and the annual investment costs for an indexed strategy may be as low as 0.2 percent annually.

Diversification is often stressed in 401(k) plans and the college savings plans. Attention to costs in these retirement and long-term savings plans is critical. The typical 401(k) plan has layers of administrative fees to cover custodial, actuarial and investment arrangements. While some of these fees are unavoidable, plan sponsors should seek to minimize their effect on employees' funds.

These costs are often largely hidden from the investor participant and over time can work to significantly reduce funds available for retirement. If you are experiencing sub-par investment returns, consider the following as possible solutions: Convert your holdings to low-cost index-type investments. Or seek an investment approach (or adviser) that has a proven long-term performance record that exceeds the market averages.



Ken Skarbeck is managing partner of Indianapolisbased Aldebaran Capital LLC, a money-management firm. Views expressed are his own. He can be reached at 818-7827 or ken@aldebarancapital.com.
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