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October 04, 2010


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The problem with index funds is that you are by definition overweighted in large cap stocks. I have no problem with index funds as part of a portfolio, in fact, to cover off the large cap domestic stock area, I will take an index fund over a managed fund any day of the week and twice on Sunday. But if you are only investing in index funds, you are not really diversified.


That depends on what index you invest in. Vanguard's index fund listing includes 8 large-cap index funds, 4 mid-cap, 3 small cap, 4 bonds, 8 international, 1 sector (Real Estate index) and 1 balanced.


There are large cap index funds, mid cap index funds, small cap index funds.

So if you buy 1/3 of each you are not over-weighted in large cap.

Now granted you are over weighted in the largest of the mid cap and the largest of the small cap within each of those indexes but given that the small cap is already stocks that are 100-500 times smaller than the largest large caps you are doing pretty good at avoiding having too many large companies. And do you really want to have equal weighting of the smallest of the smallest companies. Those companies tend to be the riskiest so having a little less of those in a weighted index doesn't seem so bad.

It's also possible you could find an index that isn't capitalization weighted. However this can have many pitfalls as well. The DJIA for example is not capitalization weighted. It is based on one share of stock in each of the 30 companies divided by the DJIA divisor. So in this case a huge company like MSFT with a stock price of 25 has 1/5 the impact of a large but smaller company like IBM with a 130 dollar stock price. Is that really what you want?

I think if you take a weighted index fund in large mid and small stocks and put 1/3 of your money in each you have effectively eliminated the large cap problem you are discussing.

If you don't think so I would be interested to know why you think that doesn't solve the problem?

One other twist is that when you actually find a "better than average" money manager, the money starts to flow into the fund. When this happens it becomes harder and harder for the manager to keep finding ways to invest the money. Also, the spotlight puts pressure on the money manager to not get beat by the market, so there is some incentive to just become a defacto index fund.

You can do what Apex suggests and if you really want to diversify,, you can further split your funds by growth and value funds. That is to be clear, large growth/large value, mid cap growth/ midcap value and the same with small.

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