Last updated on September 10th, 2019 at 03:56 pm
Disclaimer: I am not a professional financial adviser, and this series in not meant to provide individualized financial advice. I am just one guy who did well enough to become financially independent at age 35. This series simply shares the lessons I learned for your entertainment.
By The Pointer
In this series, we’ve made a lot of references to investing and the “market.” Now, it’s time to get into how investing is done, and why it’s not nearly as complicated as many people think.
Some Quick Definitions
Let’s quickly run through some basic definitions so we have a shared vocabulary for the rest of this installment.
Stocks & Dividends
When you own a share of a company’s stock, you own a small piece of that company. If you own a share of Burger King, that doesn’t mean you can walk into a store and demand a free burger because you “own the company,” but it does mean you can vote for the Board of Directors (representatives of the shareholders) that hire and oversee the company’s management. They’re meant to ensure the managers are doing a good job, and not wasting the shareholders’ money. When you own stock, you’re also entitled to dividends. Dividends are when the company distributes part of its cash/profits to its shareholders.
Bonds are essentially loans. If Ford wants needs to borrow $1,000,000 for new factory equipment, they could sell 1,000 bonds for $1,000 each. You can buy one of those bonds for $1,000, and over a certain period of time (differs for every bond), Ford will pay back that $1,000 with interest. Bonds tend to be considered safer investments, but they don’t earn as much money. They’re safer because if a company goes out of business, it has to sell its assets (eg. factories, equipment, etc.) to pay back bondholders before any money goes to shareholders. Also, the United States Treasury sells bonds, and they’ve never failed to pay back one of their loans. US Treasury bonds are typically seen by investors as the closest thing to a risk free investment.
Mutual Funds, Expense Ratios & ETFs
Mutual funds are sort of like a collection of stocks. Let’s say that instead of investing in just Burger King, you want to invest in the entire US stock market. You could search out every company in US stock market and try to buy their stock, or you could do the same thing by buying a share in a total US stock market mutual fund. Mutual funds usually have to be managed by people to make sure the fund doesn’t overbuy stock from one company or another. The expenses to manage that fund are usually shows as a percentage of the fund’s value (or expense ratio). A mutual fund with $1,000 in expenses and $100,000 in value would have a 1% expense ratio. Exchange Traded Funds (ETFs) are essentially the same as mutual funds for our purposes in this article. There some differences, but for our purposes today, we’ll treat them as essentially the same.
The Myth of the Brilliant Investment Manager
There’s a narrative in the average person’s mind that goes a little something like this:
Investing is really complicated. I’d just mess up if I do it myself so I need someone to invest my money for me. It can’t be just anyone. They have to have that “special instinct” so my investments can do better than anyone else’s. Sure, the person I hire will take a commission, but that commission is higher if the value of my investments go up so they’ll be working in my best interest. My friend knows a guy, and he made a ton in the market last year.
-The Uninformed Investor
Let’s look at the reasons that this myth is just that: a myth.
The experts know that “experts” aren’t worth their cost
Warren Buffett, the CEO of Berkshire Hathaway, is one of the richest people in the world. As of the time this installment was written, Forbes estimated his net worth was $78.9 billion. He’s also considered one of the most knowledgeable investors in the United States.
Buffett is also 83 years old, and he knows that he’s not immortal. He was very clear plans for how his money should be managed after he dies. Spoiler alert: he’s not recommending that it be managed by a mythical brilliant stock picker. Instead, he says…
My advice to the trustee couldn't be more simple: Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund. (I suggest Vanguard's.) I believe the trust's long-term results from this policy will be superior to those attained by most investors — whether pension funds, institutions or individuals — who employ high-fee managers.
No one has a “gift” for stock picking
What Buffet recommends is called passive index investing. It’s passive because you don’t have to constantly review financial data, buy a winner, sell a loser, etc. You just buy a mutual fund once, and leave it alone until you need to start withdrawing.
The index part refers to how you’re investing in a broad range of companies such as a total stock market mutual fund that mimics the performance of the total US stock market. The opposite of this approach is called active investing. Let’s discuss some of the data that shows why passive index investing almost always beats active investing.
The Macro Data
The clearest evidence in favor of passive index investing is a report that S&P Dow Jones Indicies releases every year. It looks at how actively managed funds performed compared to their benchmark index.
As you can see, active funds with “gifted” fund managers rarely outperform the index that they say they can beat. Over a 1-year period, 68.83% of them fail to beat their benchmark index. OK, maybe a few got lucky in year 1. When you look over a period of 5 years or more, you see that active funds are beaten by the index 85% or so of the time. This is why so many people agree that you can’t beat the market.
The Buffet Bet
Are you thinking, “Yeah, but what about that 15% or so of active funds that are consistently beating their index? I’ll just invest in one of those.” Well, good luck figuring out which one will continue to outperform.
Back in 2008, Warren Buffet made a $1 million bet with Protégé Partners, a hedge fund that makes active investments for its clients. Buffet bet that if he put his money in a low-cost S&P 500 index fund (Vanguard's S&P 500 Admiral fund also known as VFIAX), he would do better than if the hedge fund managed the same amount of money however they wanted. These guys are some of the world’s best active traders. Surely, their combined expertise can beat the market, right?
After 10 years, they had the results. Buffet won! It wasn’t even close! The index fund gave a 7.1% annualized return while the hedge fund only gave a 2.2% annualized return. The $1 million that Buffet won was donated to the charity Girls, Inc.
Many Active Fund Managers Don’t Have Your Best Interests in Mind
One of the other misconceptions that drives people toward active managers is the idea that these managers work on commission (they get a percentage of your total portfolio value) so they’re incentivized to do what maximizes your portfolio value. We already saw that active managers aren’t all that good a growing a portfolio in the first place. Let’s hold that aside for a second, and assume you’re working with that unicorn who can consistently beat the market. You could still be getting screwed even if they are brilliant.
No legal duty
By default, financial advisors don’t have a fiduciary responsibility. In other words, they don’t have a legal duty to work in your best interest. That’s one reason that you should only work with financial professionals that can verify they are fiduciaries.
Conflicts of interest
If they aren’t fiduciaries, they could do all sorts of things that people often don’t know about. Those include recommending that you invest in a fund where the fund gives them a bonus based on the number of clients they bring (even if that fund wasn’t best for you). They could also encourage you to invest in their brother-in-law’s fund without ever disclosing the relationship.
Active managers have to actively manage. They have to be paid for that work. That cost will be charged you. It’s not uncommon for an active manager to take a fee of 1% - 2% of the money you have invested. 1% doesn’t seem like much, but let’s say you have one of those rare active managers that can keep pace with the index. What would it look like to invest a $100,000 nest egg, and earn 7%/year in the market with and without that 1% fee:
Well, you’re going to lose about $70,000 to that active manager’s commissions on the low end (assuming the manager can keep up with the index…and we’ve already seen that most can’t).
However, it doesn’t stop there! You’re not only paying for the manager’s time, you’re also paying the expenses of the funds they choose to invest in. Each fund has what’s called an expense ratio (fund expenses over fund value). Those active managers typically aren’t having you invest in low-cost index funds (typically 0.25% or lower expense ratios). They’re encouraging you to invest in actively managed funds that are frequently buying and selling based on the latest market data so they have high costs (typically 1% - 2% expense ratios). What would that same $100,000 investment look like after 20 years if you had to pay 1% to fund expenses and 1% to the active manager versus just plopping $100,000 in a total stock market index fund with a 0.25% expense ratio?
Now, we’re looking at a relative loss of over $100,000 on an investment of $100,000 because of a myth that active managers have your best interests in mind.
Tax consequences of active management
In addition to high expense ratios, active funds can lead to a higher tax bill. Remember, every time you sell a stock, there’s a taxable event. If you made a gain, you owe taxes on that capital gain. Actively managed funds are constantly buying and selling stock. Around tax time, you could get a nasty surprise when you see how much you have to pay in capital gains taxes.
How can I do it right?
We promised specifics so here they are using Travis as our example.
Look for Index Funds That Approximate “The Market” At A Low Cost
Hopefully, we’ve already established that active investment managers rarely outperform the market, and even if they could, they charge fees that can wipe away any potential gains. OK, so how should Travis get started? Let’s begin by looking at low-cost passive index funds that mimic the performance of the total US stock market:
Vanguard, Fidelity and Charles Schwab are 3 of the most reputable investment firms in the US. They’re also well known for having some of the lowest expense ratios in the industry. These aren’t the only funds that Travis could invest in, but they all track the US stock market and have expense ratios at or near zero. It would be hard to do better.
For most people, it’s just that simple. Just take your savings, and buy one of the total stock market index funds above. Then, don’t touch it until you’re ready to retire.
Which one to choose
OK, so Travis has 5 good options, which one should he choose? By the end of year, Travis is going to have $23,353 to invest. Let’s look bucket by bucket.
For the 401k
Between his own contributions and the employer match, he’ll have $13,680 to invest. However, he might not have a choice of any of the funds above. His employer picks what 401k investment options are available. If that’s the case, just look for a fund that has an objective to match the performance of the total US stock market (or something similar like the S&P 500 or Wilshire 5,000) and has the lowest possible expense ratio.
For the Roth IRA
Travis is planning to put $6,000 into his Roth IRA. With IRAs, you can choose your own investments. In that case, I’d suggest that he open a Roth IRA account with Fidelity, and invested in FZROX. That’s Fidelity’s total stock index fund without any expenses (or at least no expenses that are passed on to the investor). It’s hard to beat zero expenses, especially from a large, reputable investment firm.
For those of you following along at home, if you have a traditional IRA, I’d still recommend FZROX. It has all of the same benefits in a traditional IRA that you get with a Roth IRA.
Note: If you open an account with another firm like eTrade or Schwab, and you try to buy a Fidelity mutual funds, they will probably charge you a fee to buy the fund. Investment firms tend not to charge fees when you invest in their own funds. In other words, open a Fidelity account to buy a Fidelity fund. Open a Vanguard account to buy a Vanguard fund. Etc.
For the HSA
Travis will have $3,500 in his HSA by the end of the year. Some people are hesitant to invest HSA money. No one wants to have to a medical emergency, and realize that they can’t pay their bill because the market is down this week. However, Travis sees his emergency fund as what he’d use to cover this kind of expense. He sees his HSA as a retirement investment account masquerading as something for medical expenses.
Remember, your HSA is completely separate from your insurer. On Travis’s paycheck, he’ll see two different deductions. He’ll pay a health insurance premium to an insurance company like Aetna, and his HSA contribution will be sent to a completely separate company. That company will likely have investment options that his employer chose. Sort of the like the 401k, that’s great if your employer picked good options. If not, that can be a pain.
However, Travis can still open his own HSA, and transfer the money from his employer’s HSA administrator to his preferred company. Personally, I’d recommend Fidelity again. They allow you to open an HSA account with no minimums or management fees, and you can choose to invest in FZROX with no expense ratio. That’s what Travis is going to do.
For Non-Tax-Advantaged Investments
After all of his tax optimization, Travis will still have $173 left over. That’s not much, but it could be more in the future if he can lower his expenses or earn another raise. Some people still have a ton of savings to invest, even after contributing the maximum to all of their tax advantaged accounts. Should they invest in FZROX?
I’d suggest investing non-tax-advantaged money in VTSAX (or VTI if you can’t meet the $3,000 investment minimum for VTSAX). Why? Because taxes! Mutual funds are buying and selling stocks all of the time to make sure their holdings reflect their index. That leads to capital gains that are taxed. The other investment vehicles we talked about are tax-advantaged so they’re not affected. Vanguard has a patent on some of their mutual funds (VTSAX is one of them) that allows them to avoid passing on capital gains to the investor until the investor is ready to sell. Basically, you can defer capital gains taxes until you’re ready to pay them (presumably when you have a lower tax rate or a 0% tax rate).
Think Long Term and Don’t Panic Sell
Remember, the stock market has ups and down, but it’s always had more ups than downs. It trends upward over time because humans make progress over time. We invent new technologies like the internet, we find ways to make gigantic computers smaller and cheaper so you put one in your pocket…we get better (at least economically speaking) over time. An investment in the stock market is a bet on human progress, and history would suggest that’s a good bet.
However, we’re only human. Back in 2008 and 2009, some investors saw their portfolios drop by 50% at the same time that their homes were losing value. They panicked, and decided to sell “before losing everything.” In reality, what they did was guarantee a loss. The market recovered like it always does, and they lost out on the gains.
Here’s what things looks for two investors who invested $100,000 at the end of 2007, just before the Great Recession. The Chicken Little panic seller saw that he lost over $39,000 in one year, and couldn’t handle it. He sold, and stayed out of the market to keep his money “safe.” Meanwhile, our cool-as-a-cucumber long-term investor didn’t panic. 10 years later, the longer term investor’s portfolio had grown to $170,709 while the panic seller was still sitting at $61,510…an over $100,000 difference.
Better off dead?
Fidelity once did an internal study of the investors who did the best over time. What did they have in common? What made them so successful? They were either dead or forgot they had a Fidelity account. The lesson: compound growth over time is extremely powerful if you just let it happen. The worst thing you can do is sell out of fear during a market downturn.
Add Some Bonds If You Want
Some people add bonds to their portfolio to reduce volatility. While the stock market can drop 50% in a really bad year, bonds are much more stable. They don’t have much upside, but they don’t have as much downside risk. Personally, I find including bonds in a portfolio to be a wimpy thing to do.
After every downturn in the stock market, it has always recovered. Sometimes, it takes years to recover, but it always recovers…and ends up even stronger than it was before. Why give up this huge upside just so the declines aren’t as harsh in the relatively rare times that they happen? You shouldn’t be panic selling in a down market anyway. If you can’t handle volatility, my own assumption is that you’ll panic regardless of whether you have bonds in your portfolio (although I’d love to see a study proving or disproving this if anyone knows of one).
Especially, for someone young like Travis, I wouldn’t recommend buying any bonds.
Add International Funds If You Want
Last I heard, the US isn’t the only country on Earth with a stock market. In fact, I’m told other countries have companies that are doing quite well. Should we own some of those companies as well?
As you can see in the chart above, the US stock market only makes up about 40% of the total world stock market. Personally, I wouldn’t neglect the other 60%. As much as I love ‘merica, the country isn’t immune to problems.
Back in the ‘80s, Japan was growing like crazy. People thought Japan was poised overtake the United States as the world’s largest economy, then they ran into a series of issue. More than 30 years later, their stock market still hasn’t recovered.
Personally, I wouldn’t want to put all of my eggs in the US basket. I feel safer with 40% - 50% of my investments in the US stock market, and the rest in an international fund. Here are some the best passive index funds for international (excluding the US) stocks:
It Really Is That Easy
Hopefully, you can see why The Pointer (and Warren Buffet) says you’re better off investing your savings in a low-cost total stock market index fund (like FZROX or VTSAX) than trying to find that mythical active fund manager who can beat the market. If you really want to “complicate” things, you can even add an international index fund (like FZILX or VTIAX).
Passive index investing isn’t a very good a get-rich-quickly strategy, but it is a simple and easy get-rich-slowly strategy!
The Living Freely Series Table of Contents
Step 3, Part 1: Cutting Expenses
Step 3, Part 2: Increasing Income
Step 3, Part 3: (Legally) Avoiding Taxes - Part 1
Step 3, Part 4: (Legally) Avoiding Taxes - Part 2
Step 4: How To Invest Your Savings
Step 5: Achieving Financial Independence