I have always been fascinated with the stock market. It is such an amazing wealth creator that is an important part of nearly everyone’s pursuit of financial independence. After I conquered my debt through “Self-Inflicted Poverty,” I turned my full attention to building up an emergency fund and learning about investing. I couldn’t wait to get started in the exciting world of Wall Street. I read every book I could get my hands on because I was determined to become the world’s best stock picker (my friends call me “turbo”). I quickly opened a Scottrade account and made my first deposit. With my head full of lessons from books like the Intelligent Investor, by Benjamin Graham, I started poring over the financials of the hot companies of the day. I even watched Jim Cramer daily to find out which stocks he thought were the next ones to follow the “$80 to $120 Rule”. Admission: I bought some of those stocks just in time to watch them drop precipitously into the “house of pain”.
To make a long story short, I didn’t have much luck with individual stock picking. It’s not that I did horribly, it’s just that my results did not justify the countless hours I spent studying financials and monitoring my positions. When I stopped to consider the value of my time, the expense and risk of trading, and my desire to spend my finite time on earth pursuing higher priorities such as church work, family, friends, and hobbies, I decided to look for a better way.
Index Fund Investing
My search led me to the Index Fund, which is simply a fund that holds numerous individual stocks intended to duplicate the performance of a market or market sector. For instance, an S&P 500 index fund consists of a fund that holds every stock listed in the S&P 500. Brilliantly conceived by John C. Bogle, the founder of Vanguard, index funds allow an investor to have access to the entire U.S. stock market (or any other market or market sector for that matter) without purchasing all of the individual stocks that make up that market.
After much research, I concluded that diversified, low-cost, index fund investing was the way to go as a core investment strategy. I came to this conclusion for many reasons including the following:
- Simplicity – Index fund investing saves me valuable time so that I can focus on my life and not get bogged down monitoring the gyrations of my individual stock positions.
- Risk management – Index funds reduce risks by spreading your investment dollars among hundreds or even thousands of companies instead of a handful of individual companies (See also Enron). Unlike individual company stocks, broad market index funds never go to zero.
- Performance – Index funds almost always perform better than actively managed funds over time. In fact, studies have shown that over 10-year periods, 80-90% of large-cap, mid-cap, and small-cap managers fail to outperform their indexed counterparts.
- Cost effectiveness – Index funds are very cost-effective. While active management usually costs between .8%-2.5% per year, index funds have an expense ratio between .05 – .14%. For instance, a Total U.S. Stock Market Index Fund at Vanguard that holds 3,578 stocks can be purchased for as little as .05% per year! Even a more exotic fund such as an Emerging Markets Index Fund only costs .14 % per year at Vanguard. And an expense ratio of 1% can really create a drag on your portfolio over long periods of time. For example, if you invested $10,000 over a period of 10 years with a 10% rate of return and a 1% expense ratio, you would lose 15.6% of your returns to expenses. However, if you invested with low-cost index funds using an average expense ratio of, say, .08%, you would only lose 1.3% of your returns to expenses — a difference of $2,226.00!
- Tax efficiency– For your investments held outside of a qualified retirement account, actively managed funds are inefficient when it comes to taxes. This is due to the frequent trading conducted by active managers as they constantly chase short-term trends and speculative trades. Conversely, index fund investing involves a “buy and hold” approach, whereby tax consequences are minimized due to infrequent selling.
What the Experts say…
Warren Buffet CEO of Berkshire Hathaway:
In Berkshire’s 2005 annual report, I argued that active investment management by professionals – in aggregate – would over a period of years underperform the returns achieved by rank amateurs who simply sat still. I explained that the massive fees levied by a variety of “helpers” would leave their clients – again in aggregate – worse off than if the amateurs simply invested in an unmanaged low-cost index fund…. The bottom line: When trillions of dollars are managed by Wall Streeters charging high fees, it will usually be the managers who reap outsized profits, not the clients. Both large and small investors should stick with low-cost index funds
Charlie Munger (Warren Buffet’s Partner):
The general systems of money management require people to pretend to do something they can’t do and like something they don’t. [It’s] a funny business because on a net basis, the whole investment management business together gives no value added to all buyers combined. That’s the way it has to work. Mutual funds charge two percent per year then brokers switch people between funds, costing another three to four percentage points. The poor guy in the general public is getting a terrible product from the professionals. I think it’s disgusting. It’s much better to be part of a system that delivers value to the people who buy the product.
William Bernstein, author of The Four Pillars of Investing:
It’s bad enough that you have to take market risk. Only a fool takes on the additional risk of doing yet more damage by failing to diversify properly with his or her nest egg. Avoid the problem — buy a well-run index fund and own the whole market.
If you are looking for a high risk, exciting investment to discuss with your friends at cocktail parties, choose individual stocks. But If you want to obtain all of the returns that the market has to offer while minimizing hassle, risk, costs, and taxes, index funds are definitely for you!! In Part 2, I will discuss how to build a diversified, buy and hold portfolio using low-cost index funds.