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Index Funds and Asset Allocation Even Better for the Wealthy?

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Wealthy investors may benefit from passive index fund investing even more than middle class.

Index funds represent a truly excellent financial product. They result in ultra-low-cost investing, provide massive diversification, and operate with razor-sharp tax efficiency.

Further, if you couple good quality index funds with a sound asset allocation formula, you get an almost unbeatable strategy over any long investing horizon.

Note: An asset allocation formula just specifies how you break down your investment portfolio into categories. Putting 60% of your money into a stock index fund and 40% into a bond index fund is one simple asset allocation, for example. You can get good discussions of several other sturdy asset allocation formulas at the Bogleheads website (click here).

But you know what? While index funds and asset allocation formulas work well for just about anybody, one can argue the combination works especially well for high income and high net worth investors.

In other words, those movies, television shows, and books that talk up the idea that wealthy folk invest in all sorts of crazy stuff? That’s maybe true. (See here for some insights we’ve gleaned from IRS statistical studies about the way the wealthy invest.) But that sort of active, hands-on investing may not be any smarter or better than index-based-asset-allocation investing.

Why? Because in addition to the benefits that everybody gets from indexing and allocating, high income and high net worth investors also gain some other notable advantages that matter a lot when the numbers grow large.

Easily Scalability

For example, a first advantage to note? The combination of index funds and asset allocation formulas provides easy scalability—which is a big benefit when you talk big dollars.

Consider this hypothetical situation: You and I happen to guess the right numbers for a giant lottery and find ourselves each holding a $10,000,000 check. Assume we both show enough discipline and common sense to save the entire windfall.

If I’m investing actively in something like rental properties or small businesses or individual stocks—anything like that—deploying the windfall will take me at least weeks and maybe months. Gosh, maybe even years.

If you, in comparison, are simply using a combination of index funds based on a decent asset allocation, you can write one or two checks and be done with the deployment. Boom.

If you’re using the 60/40 formula mentioned earlier, for example, you could write one $10,000,000 check to Vanguard and deposit the money into their balanced index fund.

Even if you’re using a slightly more complicated asset allocation formula, you can probably be done with your asset deployment is less time that it takes to make a pot of coffee. No kidding.

This scalability matters when you’re talking bigger numbers. Yet the benefit isn’t always appreciated.

Easier Successions

And here’s another benefit to using index funds and asset allocation formulas if you’re talking about a lot of money: Easier successions.

With a simple index-funds-and-asset-allocation-formula approach, you’ve got a strategy that will continue to work pretty darn well even as your life changes and even when your heirs find themselves managing the money.

This makes sense, right? You may make great money with a farm or rental property or some active investment category. But you can’t be sure your spouse will do as well or want to shoulder the burden if something happens to you.

Further, at some point obviously, you may pass your wealth to heirs who will probably be less interested or less able to deal with a specialized active investment strategy.

Indexing and allocating, however, should be pretty transferable skills. Someone could probably read a book or two and be ready to take the reins. And note that with an indexing-based approach, taking a few weeks or even a few months to read through these books shouldn’t cause any problem. An index funds approach will probably very nearly be on autopilot during any learning curve ramp up.

Note: I would recommend someone interested in using indexing and allocating read John Bogle’s Common Sense on Mutual Funds book (click here) and then, if more information is desired, read David Swensen’s Unconventional Success (click here).

A side note: The reason that succession is maybe a bigger issue with bigger dollar portfolios is that the bigger dollar investment portfolio may more likely remain intact. A modest portfolio might very reasonably be liquidated and then consumed by heirs.

Systematic and Procedural

At least one other benefit, I think, occurs when a high income or high net worth investor selects the index-funds-and-asset-allocation-formula approach. That benefit is that the approach more easily allows the investor to systematize and procedural-ize investment management.

This idea maybe sounds a little funny at first. But let me share what I’ve observed.

If you or I only need to worry about a modest amount of money, we probably don’t need to be that efficient. Sure, efficiency is good. But in many cases, saving X percent in costs here or reducing the annual time requirement by Y percent doesn’t make all that noticeable a difference.

Furthermore, if a modest portfolio is a little messy, hey, a small mess is easy enough to deal with.

If the numbers get big, however, you have to manage your investment portfolio the same way a well-run business is managed. You want to use systems to keep costs down and work quality high or at least adequate.

You possibly also need to use procedures and policies to assure that what you want to happen actually happens.

Now if you are using some active investment strategy—like rental real estate just for example—you can design and then set up these systems and procedures yourself. That works.

But most people will probably find it easier to systematize and procedural-ize a portfolio of index funds than a collection of active investments like rental properties, investment partnership interests, or small businesses.

Think a bit about the systematization baked into the index-funds-and-asset-allocation-formula approach.

The index funds approach means a computer system makes investment decisions. Automatically.

The index funds approach means that bookkeeping for the investment income, deductions, gains, and losses gets totally outsourced to a low-cost, back-office operation at some mutual fund company. Automatically.

Furthermore, the mutual fund management companies, regulators, and public accounting firms implement procedures at a bunch of different places in the process to safeguard your investments. Without any intervention required on your part.

In summary, an index funds approach way more easily lets someone create a clean, cookie cutter process. And that process should mean you’ve got a much more robust process and system to deal with a large portfolio.

Final Clarification

So does the foregoing mean that high income high net worth investors shouldn’t engage in active investments?

No, heavens no, I’m not saying that. We need these people to make the sorts of active investments they do. Their active investment activities power our economy and provide the rest of us with products and services we want.

But I am saying the indexing and allocating approach works really well for the high income and high net worth investor—often better than these people understand. And probably this approach should be the default choice made by more high income and high net worth investors.


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