by Ernesto R. Martin

There are other ways to invest in stocks. One was introduced in the 2004 book The Little Book That Beats The Market by Joel Greenblatt, a renowned academic and investor. In the book he recommends a fairly simple investment formula which had stellar results when tested over a 17 year period ending in 2004: it had an average annual return of 30.8% and turned an $11,000 investment into more than $1 million! However, in an updated version of the book the author encourages most investors to go with S&P 500 index funds, because such index funds have a decent return, while stock picking, even using his formula, requires a lot more patience and few people have the tolerance needed for the huge losses that occur in some years. More importantly, the formula has been tested in more recent years and has performed worse than the overall stock market, largely because the investment landscape is now vastly different (in the tested period from 1987 to 2004 e-commerce hardly existed, there was no Facebook or smart phones, and neither Apple nor Amazon had become the behemoths they are today). If you're still interested in picking stocks (perhaps 10% of your money, with the other 90% in an S&P 500 index fund), this website discusses the formula and its shortcomings, and presents a slightly more complex strategy that has performed significantly better in recent times.

The other approach, developed by Paul A. Merriman*, is relatively easy to implement and simply divides your investment equally into four index funds: the S&P 500 (which, as mentioned previously, consists of the largest U.S. companies and is weighed towards growth stocks like Apple and Amazon, which are expensive because the companies have rapidly expanding revenues and profits), an index fund that invests in the stock of large value companies (like banks, Walt Disney and AT&T, where the stocks are cheaper because of moderate growth), an index fund that invests in a blend of smaller companies (both growth and value), and an index fund that invests in smaller value companies. I would favor a variation, where you don't divide your investment equally among these four funds but instead have a higher concentration in the S&P 500 index fund, something like 40% in S&P 500 and 20% in each of the other 3 funds. The equal-four-fund approach has historically shown greater returns than simply one in an S&P 500 index fund, and because of the greater diversification it has less volatility; the names of the recommended index funds are shown below and you can find details here.

* Paul A. Merriman is a financial educator and advisor on mutual funds, index investing, and asset allocation. As an author and speaker, he has led investor workshops, hosted a weekly radio program and has been a featured guest on television shows. In 2011 he formed an LLC to support the PBS project "Financial Fitness After 50" and the "How To Invest" series of print and eBooks.