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A Lesson on Index Fund Investing

- Alan Lavine and Gail Liberman

Should you invest in an index fund that owns all the stocks thatmake up the S&P 500?

The S&P 500 is an index of the 500 largest, most profitableU.S. companies. The Vanguard 500 index fund is considered thelowest cost and most popular index fund, according to MorningstarInc., Chicago. And this fund outperformed the vast majority ofactively managed stock funds over the past 15 years.

Despite the S&P 500's track record, some financial adviserssay you should not put all your money in an index fund. It's betterto diversify stock fund holdings. David Marotta, president ofMarotta Asset Management, Charlottesville, Va., says that the S&P500 might be a core holding. Nevertheless, you also need todiversify stock fund holdings among large, medium and small companystocks as well as bonds. Different types of stocks and bondsperform in cycles. So when one type of stock is doing poorly,another stock or bond may be increasing in value.

The big problem with only investing in the S&P 500: You justown large company growth stocks. Also, an index fund stays fullyinvested. So when the market tumbles, you go right along with it. Second, the index is market-weighted based on a stock'scapitalization rate. The capitalization of a company is determinedby multiplying the stock price times the number of shares that areoutstanding for that company. That means that the stocks with thebiggest market capitalization make up the biggest parts of theindex.

The 10 largest capitalization companies make up about 23.4percent of the S&P 500 index. When you invest $1,000 in the 500index fund, you are not investing $2 in each of 500 companies.Rather, a full $234 of the $1,000 investment goes into the top 10companies, which include General Electric, Microsoft, Exxon-Mobil,Pfizer, Citicorp, American International Group, Johnson & Johnson,Coca Cola, and Intel.

Due to these factors, S&P 500 index funds are aggressive andrisky investments. By contrast, managed funds, he says, are muchless risky and volatile. The reason: The fund managers can takedefensive action in down markets to limit losses.

"Are we telling you not to invest in the S&P 500 Index mutualfunds?" Marotta says. "No, only that you not invest all of your401(k) or other monies in only that index. You need foreign stocksand inflation-hedged stocks and possibly some bonds."


Alan Lavine and Gail Liberman are husband and wife columnist and authors of The Complete Idiot's Guide To Making Money With Mutual Funds, (Alpha Books).

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