In previous articles I’ve covered why it’s so difficult for people to beat the market. How Warren Buffett is an anomaly and how it’s so hard to beat the market that only 5% of fund managers manage to do it. Far fewer individual investors can do it and why this is one reason I don’t use a financial planner.
So why is it so tough to beat the market and what should we do to maximize our investments?
I cover several of those reasons in this article. So if it’s so difficult, what should we do? Not invest? Spend all our money, seems to be the answer most people give. People who don’t understand or trust investments are much less likely to put their hard-earned money somewhere they don’t have confidence. That’s why it’s so important to be educated about the options. Once you learn a bit about the market, it becomes apparent that the simplest solution is the most effective.
You don’t have to have a degree in Finance, like I do, or be a CPA to understand investing and financial independence. It’s not complicated. In fact, it’s pretty easy.
Here are the steps:
- Invest a set amount every paycheck or whenever you get paid.
- Put it into an index fund like VTSAX from Vanguard
- Leave it alone for as long as possible to let compounding take effect.
- Take advantage of options to reduce your taxes.
- Ignore everything else. Don’t watch CNBC or read the Wall Street Journal. Don’t listen to friends and family who have “hot tips” to share. Go outside and live your life.
index funds always win
Warren Buffett is widely considered to be the greatest investor of all time. So we should start with him. What does he say people should do with their money?
He, among other very successful professional investors, suggest just buying a U.S. market index fund. Buffett told CNBC’s On The Money in an interview recently that everyone should “Consistently buy an S&P 500 low-cost index fund…I think it’s the thing that makes the most sense practically all the time.”
Tony Robbins (half a billion net worth) added, “When you own an index fund, you’re also protected against all the downright dumb, mildly misguided or merely unlucky decisions that active fund managers are liable to make.”
Mutual funds have a very difficult time beating the market, which is why index funds are a better choice. Research from Standard and Poor’s shows that the chances that a mutual find will beat the S&P 500 over a 15 year period is about 5%!1
Buffett was so confident that index funds would do better he made a bet with a successful fund manager that an index fund would outperform a fund-of-funds over 10 years. He won the bet.
He summarized the results in his 2016 annual shareholder’s letter:
“The compounded annual increase to date for the index fund is 7.1%, which is a return that could easily prove typical for the stock market over time… The five funds-of-funds delivered, through 2016, an average of only 2.2%, compounded annually. That means $1 million invested in those funds would have gained $220,000. The index fund would meanwhile have gained $854,000.”2
Why did the index fund win?
The answer is simple: Fees. Fees will drag down the performance of your portfolio consistently over time. Let’s do a comparison to illustrate:
The average Expense Ratio of a managed mutual fund is between 0.5% and 1.0%. International funds are between 1.25% and 1.4%.3 You can take a look at the top recommended mutual funds by U.S. News here and see most fall within this range.
If you use a financial advisor, you can add an additional 0.5% to 1.0% in fees.
Mutual funds are more expensive because it costs money to pay the fund managers, researchers, staff, trading fees, fancy office overhead, etc. Those costs are passed on to the investors. Index funds don’t have any of that overhead.
For comparison, VTSAX (which also happens to be the world’s second largest fund), has an expense ratio of 0.04%!
Those differences may not sound like a lot, but consider that the drag of those fees compounds. Let’s say the difference is just 1%, which is very conservative. If you put $500 into your 401k or brokerage account for 30 years, that 1% adds up to over $210,000! That’s a lot to pay for choosing the wrong mutual fund. Not to mention, for making things more complicated than they need to be, which people often do by choosing a mix of 10-20 mutual funds because we think we need to be over-diversified.
For a more detailed look at index fund investing, check out the Vanguard white paper “The Case of Low-cost Index Fund Investing.” 4
So what about diversification?
The low fees sound nice, but does an index fund give me enough market exposure and diversification? Yes and yes!
If fact, you’ll have greater diversification and exposure. Mutual funds are not the market. In most cases, they are a subset of the market – an asset class, geographic location or type of stock. For example, a U.S. small cap mutual fund buys U.S.-based stocks with a market cap less than $10 billion.
So if you invest in that mutual fund, you’re not very diversified and will need to add more funds to round out your portfolio. You’ll need to check that the second fund’s holdings don’t overlap the first fund and negating some of your attempted diversification. The more funds you add, the more complex things get.
What about international stocks?
Holding shares of a popular U.S.-based index fund like VTSAX means you’re investing in U.S. companies. What about the rest of the world, especially emerging markets which can have high returns (and high risk)?
First, the GDP of the U.S. makes up about 25% of the world GDP. 5 Second, the top U.S.-based companies that make up the build of the value of an index are international with office around the world that earn revenue in countries around the world. An index fund may invest in companies that are based in the U.S., but those companies are well diversified, so buying an international fund would double your international exposure. Not the worst thing in the world because there are some amazing countries around the world, but something I avoid because it further complicates things unnecessarily. If you disagree, I’d love to hear your thoughts in the comments below.
Leave it alone so compounding works for you
Fidelity conducted a study that exemplifies the advantages of leaving your investments alone so they can compound, rather than day trading or even thinking about them much at all.
They looked at which accounts performed the best over time and found the second best performing accounts were owned by people who forgot they had an account at Fidelity. The highest returning accounts were those of deceased people. In other words, accounts with no trading.
Despite what Gordon Gecko taught us, investing is boring. Set it and forget it is the strategy with the highest long-term success. You can safely ignore all the financial experts on TV and cancel your subscription to that hot stock tip service that will teach you how to be rich. Even ignore the tips from that co-worker who frequently gives out advice of what the next hot investment is. Ignore all of it, save yourself a lot of time and actually earn higher returns. Sounds like a pretty efficient method to me!
Ignore all other advice and focus
The fact that people just can’t leave their portfolio alone is why most investors can’t beat the market. They need action and movement to feel like they’re doing something. How can my portfolio really do well if I’m not tweaking it after watching CNBC and reading the Wall Street Journal all day? Well, the data shows that you don’t need to do either of those. You don’t need to know much about the stock market at all do to well.
Maybe this is why Warren Buffett suggested that stock prices should only be reported once a year. The daily prices just don’t matter. All you need to do is trust in an index fund like VTSAX, put away as much as possible and check back much later.
As Jack Vogle, the founder of the Vanguard Group, the world’s largest investment company said,
“As I have said before, the daily machinations of the stock market are like a tale told by an idiot, full of sound and fury, signifying nothing…One of my favorite rules is ‘Don’t peek.’ Don’t let all the noise drown out your common sense and your wisdom. Just try not to pay that much attention, because it will have no effect whatsoever, categorically, on your lifetime investment returns.”6
If you diligently put money into an index fund and don’t worry about it, Jack Vogel says when it comes time to start living off that income, you’ll be amazed at what it’s grown to.
Next, we’ll take a look at how taxes can affect your returns and how we can reduce our taxes as low as possible.
To be notified when the next article is published, join the newsletter.
GET RESEARCHED-BASED TIPS ON HOW TO GET BETTER, FASTER.