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Index Investors Can Be Aggressive Too

From time to time, I hear people suggest that if you’re an aggressive investor you may want to use actively managed funds rather than index funds–the reason being that actively managed funds have the potential to outperform their benchmarks, whereas index funds do not.

That line of thinking is nonsense.

To back up a step: The goal of aggressive investing is not just to increase risk, but to do so in order to increase the expected return of your portfolio.

And as we’ve discussed before, if you switch from low-cost index funds to higher-cost actively managed funds, you actually reduce the expected return of your portfolio–unless, that is, you have a method for reliably picking above-average funds. (I have yet to see such a method, but I’m willing to hypothesize that somebody out there has one.)

But let’s go ahead and point out the obvious: If you have such a method, wouldn’t it make sense to use it regardless of whether or not you’re an aggressive investor?

To recap:

  • If you have a reliable method for picking top-performing active funds, you should use it.
  • If you’re like the rest of us mere mortals (and you don’t have such a method), you should stick with index funds or similarly low-cost ETFs.

It’s got nothing to do with risk tolerance.

Changes that Would Increase Your Expected Return

There are, however, some steps that aggressive investors can take that actually would increase their expected returns.

[Please understand that I’m not encouraging you to increase the level of risk in your portfolio. I’m just saying that if you were interested in doing so, there are better ways to go about it than investing in high-cost actively managed mutual funds.]

If you want to increase your portfolio’s risk and expected return, just change your asset allocation accordingly: Increase your allocation to stocks or shift your stock allocation toward particularly high-risk categories of stocks (i.e., small-cap stocks, value stocks, or emerging market stocks).

For example, the following simple portfolio would be extremely aggressive, while still having an average expense ratio of just 0.25%:

  • 50% Vanguard Small-Cap Value ETF,
  • 25% Vanguard FTSE All-World ex-US Small-Cap ETF, and
  • 25% Vanguard MSCI Emerging Markets ETF.

In short: The fact that an investor a) wants high returns and b) is willing to take on a lot of risk in the hope of achieving those returns does not suddenly make it necessary or wise to pay exorbitant costs to fund companies and/or brokerage firms.

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Comments

  1. Vanguard’s Wellington Fund (VWELX) may be the exception to the Index vs Managed expected returns.
    Certainly not aggressive, but a great fund for many years, since 1929.

  2. I have tried to overweight some of the international and emerging markets ETF (through Schwab) however since they have been underperforming the S&P 500 my portfolio overall is doing worse than either that index of the dow jones. It’s tough to swallow but I’m hoping in the long run it’ll be higher overall.

  3. Mike
    I agree with what you are saying but I would add – consider valuation when changing your asset allocation. March 2009 would have been a good time to increase equity asset allocation. After the market has doubled may be the time to reduce your equity asset allocation.
    Thank you.
    Ken

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