So if you've been reading the blog thus far (I hope you have) , you've seen that we've been working our way up the important concepts that are essential for us in successfully investing for the long term. We learned the power of Compound Interest and Dollar-Cost Averaging with our golf buddies Micheal and Jim. (If you would like a refresher check out the previous blog posts ). Hopefully with the last blog post, I helped demystify what creates long-term Stock Market growth. Remember we're not worried about the emotional swings in the short run. We can't predict them. In fact, no one can.
Now, the question becomes, what do I invest in? In this blog post I'm going to discuss Index Funds, which is one type of asset that is a great building block for any investor's portfolio. It's certainly not the only one by far, but it's a great asset for the layman investor to start with. Another asset that some of you may have heard of, and may currently be invested in through your 401(k)'s, is a Mutual fund. They are both very similar to one another, except for one major difference. In fact, this major difference can be THE deciding factor between being a successful investor and a not so successful investor particularly in the long-run. Shall we?
A mutual fund, to give you a technical definition from Fidelity, is a "fund where investor's money are pooled together to purchase a collection of stocks, bonds, or other securities (or assets), referred to as a portfolio, that may be difficult (and costly) to recreate on your own. Mutual funds are typically managed by a Portfolio Manager." In layman terms, you and a bunch of other people collectively put your money into a pool and that pool is managed by a so-called expert.
This so-called expert promises you that he will take your hard-earned, precious cash, invest it in the right stocks, bonds or other assets, and by the end of the year beat the growth of the market. If the market grew at a 10% rate, then he will beat it. He'll grow your money by more than 10%. How does he do it? Well, he doesn't actually. In fact, many of them don't. "96% of actively managed mutual funds fail to beat the market over a sustained period of time." (A quote from Tony Robbins' book Money Master the Game) Not only that, there are so many fees that they charge you, which over a period of 50 years or even less can eat up half of your profits.
Let me put it to you this way: If someone came up to you and said, "Give me your money. I'll manage it. I'll pick the right assets so that you beat the market every year, but here's the thing. YOU are going to put up 100% of the cash. YOU are going to assume 100% of the risk. I put in NOTHING. If I lose all your money, tough luck, but if I make you money, I keep roughly 60% of your profits." Would you take that bet? HELL NO!!! That's just common sense. After knowing this, why would ANYONE invest in a mutual fund!? Well, for one thing we don't get told upfront about all the hidden fees that we have to pay. Also, we must not forget the power of Marketing. Marketing can make a huge difference!
Let's take a look at some of the fees that mutual funds pass on to their investors:
1) Expense Ratio--It takes money to run a fund. The expense ratio can also be thought of as management fees or operating costs to run the fund. A Mutual fund that is actively managed (meaning the fund is actively trading stocks to meet the funds goal. Remember the Fund's goal is to beat the market) will incur higher operating costs to run. The more actively managed the fund the higher the expense ratio.
2) Sales Charge or Commission--When you buy a share of a mutual fund you pay a commission to the fund. This is sometimes known as a Sales Charge or a "front-end load." (For all my actor friends out there, imagine having to pay an agent upfront just for signing with them and then on top of that paying them commissions. SCAM!!)
3) Redemption Fees--This is also known as a "surrender charge" or "back-end Load" that you get charged for selling your shares of the fund. (Once again, for my acting buddies out there, Imagine having to pay a fee to an agent if you decide to drop them. SCAM!!)
4) Turnover Costs--An actively managed fund is constantly trying to beat the market. As a result they have to constantly trade stocks (Buy and Sell) to meet this goal. Every time the fund buys shares of a company, they sell shares of another company creating turnover. Buying and selling is not free and costs the company a fee, which of course they pass on to the investors.
5) 12(b)1 Fee--This is a marketing fee that investors have to pay in order to cover costs of a fund's advertising.
These are just a few of the many other fees that can be charged to the investors. When you add up all the fees included, the layman investor, on an annual basis, may pay between 2-3%. That doesn't sound like much does it? But let's see what happens when we apply some math, cause you know, math is the most honest of the sciences. Here's an example taken from Jack Bogle's Book "The Little Book of Common Sense Investing" (Can you tell yet that I really really really like this book?).
This example is taken from Chapter 4 of the book. Lets set the scene:
$10,000 is invested in a mutual fund over a time period of 50 years. Lets assume the average annual rate of return of the stock market is 7%. The mutual fund charges you 2% in fees. That means the mutual fund will give you a rate of return, every year for 50 years (assuming it can match market return), of 5% (7%-2%=5%). With me so far? Now, here's the amazing thing and this will really illuminate how costly mutual funds are. At the end of the 50 year period, the market grew our $10,000 to $294,000 (7% growth compounded every year for 50 years). On the other hand, the mutual fund grew our $10,000, over the same 50 year period, to only $114, 700. That means we lost $179,900 dollars in costs alone. Imagine if we included dollar-cost averaging. The losses could have been half million dollars or more!!!!! We lost 61% of our earnings to fees! And remember: WE put 100% of the money in, assumed 100% of the risk and only came out with 39% of the profits. I don't know about you, but I need to go scream into a pillow.
Here's a graph showing you the progression of the example discussed above just in case you needed more proof:
So, do you agree with me now when I say mutual funds are a trap for any investor?
An important rule to remember for all investors out there: Just as your growth compounds every year, so do your costs. WE HAVE TO KEEP COSTS LOW, SO THAT WE KEEP MORE OF OUR EARNINGS!! As Jack Bogle says, "Fund performance comes and goes, but costs go on forever." Also a gentle reminder, all the costs discussed above don't include the cost of taxes we have to pay on our returns, so add that to the mix (We'll talk about the cost of taxes and inflation in future blog posts).
I know the blog post has been quite grim thus far, but it is important to understand the traps that are out there. Wall Street likes to make things complicated. It works to their advantage in taking our money when they use complicated lingo and fine print to hide compounding fees.
As I said in the previous blog post, Long-term growth of the stock market is due to the enterprise of our corporations and, therefore, if we simply invest in our corporations, our portfolio, over the long-run, will grow as well. But how do we do that? Do we buy shares of every company out there? Isn't that expensive? Yes it is, but thanks to Jack Bogle you don't have to do that. You simply have to buy into an index fund (Sometimes known as an exchange traded fund or ETF for short). What's that?
An index fund is like a mutual fund in that it's a fund that pools investor's money together to invest with, however, unlike mutual funds, index funds do not try to beat the market. They simply try to track it or copy it. For example you may have an index fund that tracks the S&P 500 (an index of the top 500 companies of the United States--Apple, Google, Facebook, Amazon). Essentially the portfolio of the index fund is a basket comprised of shares of stocks of each of these companies. What we do as investors, is we buy shares of the index fund, which trades like a stock--the index fund has a ticker symbol (an abbreviation which the stock goes by on the market, ex. Apple is APPL) and a stock price set by the market (Supply and Demand). By investing in the fund, we invest in pieces of all these companies. It's a great way for us to reduce our risk because we're not putting all of our money in one basket (i.e. Facebook, or Amazon), but instead we're investing in a broader part of the economy.
Again as layman investors or passive investors, we want to invest in the whole of American Business because we don't have time to pick the next Apple. Also an important thing to remember is that when we invest in an aggregate (S&P 500) we reduce our risk than when investing in any individual company (Amazon).
Let me give you a sports metaphor to make this point more clear: The sport of basketball will live longer than any individual athlete that plays the sport of basketball. The individual athlete's career is more finite than the sport of basketball. You can rest assured that the sport of basketball will be around far longer than any athletes individual career no matter how great they are. SO, if you, as an investor, had to put your money somewhere for less risk, but more reward you would invest your money in basketball instead of any individual player. Now, of course as you become more knowledgeable and proficient in your understanding of basketball, and you have a bit more extra cash sitting around, then sure, you can scout for the next Lebron James, Kobe Bryant, or Michael Jordan, but of course that's more risky and takes more time. And even if you are trying to scout the next Michael Jordan, it still makes sense to have the core of your portfolio invested in the entirety of the sport.
Because Index funds are simply trying to track the market or copy it, the fees are severely low. There are no turnover fees, because the fund isn't trying to beat the market. There are no "load" fees on the front end or back end and there are no marketing fees. The only fee that you have to pay is the expense ratio or operating costs. But, again, because these aren't actively managed funds, the operating expenses are quite low. In fact, the Vanguard S&P 500 Index tracking fund (which I HIGHLY recommend) has an expense ratio of 0.04%! That's it! That means in the long run we keep more of our profits!
Now, I would like to mention that since index funds match market performance they will go up and down with the market. If the market is up then the index will reflect that and if the market is down the index will reflect that too. But remember what we talked about in the last blog post about long term stock market growth. History has shown us that American businesses are resilient creatures. When the market falls, American businesses bounce back and we are betting that they will continue to do so into the future of our lifetime. (if you don't believe they will bounce back, remember what I said about that notion in the previous blog post)
The Vangaurd S&P 500 index tracking fund is a great place to start with your investment portfolio. If you're wondering where to buy them you can go to the Vanguard Website to start investing (https://investor.vanguard.com/etf/). Vanguard is a great fund to put money into for the Mainstreet investor. Jack Bogle's mission was to get Mainstreeters like us more involved in investing so that we could take more control of our financial freedom (And NO I am not getting paid to say this) You can also open up a brokerage account on E*trade or Schwab (https://us.etrade.com | https://www.schwab.com/) For E*trade and Schwab you do have to pay a commission fee of about $5-$7/trade. Make sure to factor that into your decision.
I've chosen to invest my money through an app known as Acorns. It's a really great app that allows me to put my money into preset portfolios of index funds. For example I am invested in a moderately aggressive portfolio that is made of Index funds tracking the S&P 500, Small-Cap Companies (Smaller-Valued companies), International Large Companies, Real Estate Stocks, Government bonds, and Corporate Bonds. Acorns sets the allocation of each dollar I put in based on Modern Portfolio Theory (Harry Markowitz's theory that helps explain how to maximize returns for a given amount of risk. We can discuss this theory in a future blog post) If you want a breakdown of how my dollar gets invested, here it is below:
$0.38--Large U.S Corps (S&P 500)
$0.14--Small U.S. Corp
That's literally what my portfolio looks like. Again this is where I am starting. As time goes on and I become more proficient in my abilities and have more money on hand I can invest in individual companies and try to pick winners. But these holdings will always be the core of my investment portfolio. Oh and I forgot to mention, the total expense ratio of the portfolio is only 0.65%. Thats the beauty of index funds--low cost, reduced risk, and spending less time worrying about market swings. We will discuss risk allocation more in depth in a future blog post, but for now index funds are a great place to start for the Mainstreet investor.
I hope you found this blog post useful and informative. And if you don't believe me on how great index funds are, then let me take a quote from Jack Bogle's book, The Little Book of Common Sense Investing, "...in establishing a trust for his wife's estate, Warren Buffett directed that 90% of its assets be invested in a low-cost S&P 500 fund."
Check out Warren Buffett's thoughts on index funds in this great video