You’ve resolved to start saving for your retirement. You’ve decided to use low-cost, index funds as your core investing strategy. You’ve even chosen your perfect asset allocation. The only thing left to do is pick your investments. And in the index world, your investment mix boils down to whether you’re a lumper or a splitter.
As a primer, you can divide the market into different segments. You can first segregate it by size or “market cap,” which represents the value of a company’s outstanding stock. For example, a large-cap stock like Apple, currently has a market cap of $457 billion, while a small-cap company like iRobot Corp has a market cap of $1.1 billion.
In addition, you can divide the market into different qualities of stocks – growth, value, and income.
- A growth stock refers to a company that usually reinvests its earning to produce steady, consistent growth. Think Wal-Mart. Growth investors focus on an increase in share price due of the stock’s above-average growth rates.
- A value stock represents a company that has been incorrectly valued by the market and thus trades at a lower price compared to its value. The determined value comes from a comparison of different fundamental analysis techniques like a stock’s price-to-earning ratio, price-to-book ratio, and dividend payouts. Value investors try to buy an under-valued stock and hold onto it until it reaches its true value.
- An income stock is a mature, stable company that pays regular dividends. These stocks, most often utilities, don’t offer much growth, but pay consistent dividends for investors seeking regular income.
Index funds replicate the performance of a specific index, and they come in a variety of flavors based on size, type, and quality. For instance, you can find a total stock market index, total bond market index, REIT index, value index, large cap index, small cap index, on and on and on.
The wide array of indexes allows you to tailor your portfolio to any type of asset mix you want. Consequently, the debate becomes whether you just need to cover the very broad asset classes: domestic stocks and bonds, foreign stocks and bonds, and specialty stocks (i.e., a lumper) or whether you break up those asset classes to provide even more diversification and tailoring of your portfolio (i.e., a splitter).
Lumpers take a simple approach. They choose one total market fund for each asset class. You may have also heard this approach referred to as “the lazy man’s portfolio.” The rationale behind this strategy relies on the overarching premise of index funding: markets are so efficient that no segment of the market can offer superior long-term returns. Further, segmenting your portfolio could open you up to unnecessary risk.
Simplicity is key.
Many admired investors like Vanguard Founder John Bogle use this approach. For example, he believes that when it comes to your equity portfolio, at most you should have four or five funds:
- 50% Large Cap Stock index
- 10% Mid Cap Stock index
- 20% Small Cap Stock index
- 10% Specialty Stock (health, Real Estate, etc) index
- 10% international stock index
In addition, many of the Vanguard Target Date Funds (funds that choose your asset allocation for you based on your age) use four funds – Total Stock Market Index, Total International Stock Index, Total Bond Market Index, and the Total International Bond Index.
In the end, lumpers believe this approach covers all of the necessary market sectors and prevents any unneeded over-diversification.
Splitters, on the other hand, suggest splitting the larger segments into different sectors because of their differing returns. Historically, value stocks have had higher returns than growth stocks. In addition, small stocks have and higher returns than larger stocks.
Splitters believe that weighting the growth, value, small-cap, and large-cap components of your portfolio reduces overexposure to certain types of stocks that have historically produced lower returns.
Investment guru William Bernstein tends to side with the splitter camp. Regarding equities, he believes that in sheltered portfolios (IRAs, 401ks, 403bs, etc) you can hold many stock indexes including:
- Vanguard 500 Index
- Vanguard Value Index
- Vanguard Small-Cap Index
- Vanguard Small-Cap Value Index
- Vanguard REIT Index
- Vanguard Precious Metals
- Vanguard European Stock Index
- Vanguard Pacific Stock Index
- Vanguard Emerging Markets Index
- Vanguard International Value
You can see that Bernstein’s equity portfolio doubles the amount of funds in Bogle’s.
How to pick
I can see both sides of the debate. Keeping things simple prevents over-tweaking and over-diversification. Plus, it makes rebalancing easier.
Conversely, the historical research we have may prove useful in balancing your overall portfolio. And while you hear over and over again that past performance does not predict future returns, I think you can get some value from hedging against the different market segments that have historically performed poorly for the amount of risk they contain.
But the debate has gone on for a while and is far from resolved. At this point, it boils down to personal preference. I don’t think you can go wrong either way, as long as you watch your investment costs and have the proper asset allocation.