Farrell: Playing a market hunch? Limit your bet to 10 percent

Q It sounds like you are a believer in Standard & Poor's index funds because of the fees. Is that correct, and if so, do you recommend any in particular? I have heard that Vanguard is good, and they charge 0.17 percent. 

I believe that over the long haul dividend-paying stocks, technology and emerging markets look to be very good sectors to be in. Can you recommend a way I could get a little bit more exposure to these sectors than what one would get in just an S&P index fund?

I do understand you are already getting international exposure by investing in the S&P.  When I took Vanguard's online questionnaire, it suggested that I put 42 percent of my portfolio in the Total Stock Market Index Fund, 18 percent in the Total International Stock Market Index Fund, and 40 percent in the Total Bond Market Index Fund.

This ratio puts me at about 70 percent stocks and 30 percent bonds.

DOUG, RICHFIELD

A You're right in saying that I'm a fan of investing in equity index mutual funds, bond index funds and comparable products such as broad-based exchange traded funds or ETFs. A majority of actively managed mutual funds typically underperform the so-called passive index strategy. A major reason is that you aren't paying a steep fee for a high-priced professional manager and a team of analysts. Instead, you'll do as well -- or as poorly -- as the underlying index minus a low annual charge. Nobel laureate William Sharpe rightly called indexing "a dull, boring way to be a better investor than many of your friends."

The mutual fund giant Vanguard is the pioneer in index fund investing for individual investors and it remains a flagship for low-cost, broad-based index funds. I also like comparable products at TIAA-Cref and Fidelity. (Full disclosure: I own index funds at all three companies.) I believe broad-based equity, bond, and other major indexes should form the core of a long-term portfolio, adjusting for age and financial capacity for taking risk.

"Actively managed mutual funds consistently fail to produce superior returns," writes David Swensen, a legendary investor and author of "Unconventional Success: A Fundamental Approach to Personal Investment.'' He says that, "when taking sales charges into consideration, the failure of actively managed mutual funds reaches staggering proportions."

However, sometimes we want to make a slightly bigger bet on a sector -- like you. These should be small satellite investments to your core strategy. I would recommend exposing your portfolio enough to your idea that you can enjoy a nice payoff if you're right yet not so much that your portfolio is at risk if your idea turns out to be a dud. Typically, making an overall bet of less than 10 percent with your satellite investments passes the prudence test -- big enough to count, not large enough to be disastrous.

My recommendation is to spend time researching your choices at a data service like Morningstar. Among the areas you mentioned, a number of funds look intriguing, such as Technology Select Sector SPDR, Vanguard Emerging Markets, Vanguard Dividend Appreciation Index, and the WisdomTree Large Cap Dividend. These aren't recommendations. It's illustrative of the kind of homework I would do before taking a stake in a stock market sector.  

Chris Farrell is economics editor for "Marketplace Money." Send your questions to cfarrell@mpr.org.

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