What I Learned When Stocks Tanked

Watching your portfolio increase in value is a blast. But watching as stocks decline is far more instructive. The market has recently provided that unpleasant learning experience, and I learned something unexpected.

To back up a minute: In my opinion, you should always have the bulk of your portfolio in index funds. These funds give you diversification without the hassle of managing a substantial portfolio of hand-picked securities.

However, there are also good reasons to invest in individual stocks, as I’ve done with the Practical Investing portfolio. Those reasons include controlling for a specific objective, such as boosting yield or reducing risk, and learning about how markets and individual stocks work.

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One of the goals of Practical Investing is to manage risk, or volatility. The market’s precipitous drop between December 3 and December 24 shaved 16.4% from the value of the Vanguard Total Stock Market exchange-traded fund (symbol VTI), the index fund I use as a benchmark. The Practical Investing portfolio dropped just slightly less—16.1%. But given that Practical Investing has a large share of its assets in Apple (AAPL), which declined far more sharply than the market (making it a crazy bargain now, in my opinion), I thought the rest of the portfolio was performing as hoped.

My other portfolio. What surprised me was the performance of a piece of my index fund portfolio, which is made up of funds that mimic big company, midsize company, real estate and international indexes. I also own a so-called smart index fund, Invesco FTSE RAFI US 1000 ETF (PRF). I bought it about 10 years ago because it was supposed to weed out overpriced shares.

You see, both the biggest strength and the biggest weakness of most index funds is that they don’t discriminate. They hold every share in the relevant index, generally in direct proportion to each company’s market capitalization, which is its share price times shares outstanding. Thus, Microsoft, Apple and Amazon.com, among the most highly valued companies in America, are the top holdings in VTI, making up more than 8% of the portfolio.

Research Affiliates, an investment firm that developed the indexing formula for the Invesco fund, argues that the market is emotional, regularly bidding up the price of popular stocks well past what’s reasonable. Because a firm’s weight in most indexes is determined solely by market value, you’d expect most market-cap-weighted funds to be loaded with overpriced shares. Research Affiliates instead weights companies by an array of factors, including revenue, book value, cash flow and dividends, raising the odds that the strongest companies will be most prominent in the index, regardless of their stock price.

This approach made a lot of sense to me. I also thought the fund would be less volatile than an ordinary index fund and therefore deliver better long-term results. But when this “smart” fund got hit harder than the market as a whole in December, I took a closer look. As it turns out, my assumptions were wrong. The Invesco fund has mostly kept up with the long-term results of the Vanguard Total Stock Market ETF, but over short periods, it experiences sharper swings.

This may be because the formula discounts “hot” stocks and pushes up some that are out of favor. Meanwhile, Vanguard’s Total Stock Market has performed admirably in good times and bad. The differences between the two funds aren’t dramatic enough to spur a rash shift in my portfolio. But when I need cash, I just might take it out of the smart fund, which has turned out to be a bit less clever than I’d hoped.