Starting out with index fund investing and had a question. What are your thoughts on diversification in regards to focusing on compounding interest. My understanding of it is that it would be better to focus on one index fund to garner the greatest compounding. Would that be right? Thanks in advance and love the content!
Hey @Gavinp1099!
So… I think you may be getting things a little confused here. Diversification basically means investing in lots of different stuff to mitigate the risk of owning fewer things. Diversification is great because it means you get equal or better expected returns, with lower risk. They say diversification is the only “free lunch” in investing.
That said, diversification can happen inside of an index fund. For example, the index fund VTWAX holds over 8,600 world stocks. Basically every publicly traded company on earth. If you own that one fund you are fully diversified among global stocks. (You could achieve further diversification in a non-stock asset class, like bonds or physical real estate as well)
That said, I think you may be asking about the math behind compounding when you own multiple things or in multiple accounts. Basically owning multiple funds in multiple accounts doesn’t hurt your compound growth. For example, VTSAX and FSKAX are two “Total Market Index Funds”. They have virtually identical performance. Consider these two investing strategies:
- Invest $1,000/month in VTSAX in a Vanguard Account
- Invest $500/month in VTSAX in a Vanguard Account and $500/month in FSKAX in a Fidelity account
Those two strategies will have nearly identical performance. There is no mathematical benefit to grouping all your money into a single account/fund nor is there a benefit to needlessly spreading it out.
That said, I’m a fan of simplicity. I think keeping things more clean and simple is more likely to make you more rich (so I’d clearly choose option 1 above for the simplicity). So if you want to dump all your money into a low fee, broad market index fund, I say go for it! If you really want a hands off, set-it-and-forget-it option, I’d also check out target date index funds.