For money managers and the financial press, this is the season for predicting the year ahead and celebrating (or making excuses for) their 2013 performance. If you listen to the experts as you plan an investing strategy for 2014, you’ll hear: “It’s all about blocking and tackling,” or, “We’re playing defense going into Q1...” The football metaphors play right into the image of professional investors as tough guys on the financial gridiron. You need to be nimble and ready to change your game plan on a dime (or a nickel). You’ve got to pay up for top talent in order to compete with deep-pocketed teams. And, of course, at the end of the day, the whole point is to win.
Investing, however, is nothing at all like football. There are few better ways to destroy wealth than to change your game plan every time Mr. Market lines up in a different formation. With investing, cheaper is actually better. And trying to win has been proven to be a loser’s game—in fact, by always playing for the tie, you’ll end up far ahead of the competition over the long term.
The football metaphor is useful because it reminds us of the source of so many investing mistakes: the idea that if you have enough skill and grit you can triumph. Skill and grit are necessary for getting a promotion, fixing a leak under the sink, and helping your girlfriend achieve orgasm. But they can be counterproductive in your retirement account.
Let’s go to the videotape: After the great bull market came crashing down in 2000, stocks went nowhere for more than a decade, according to the major indexes. The S&P 500, which hit 1,527 that year, started 2013 at 1,426. The Nasdaq, which peaked at 5,408 13 years ago, hasn’t come close to that mark, and was recently just over 3,700.
The experts point to these miserable numbers as proof that buy-and- hold investing is dead, and argue that you need highly paid experts to man- age your money through that kind of turmoil. In fact, the key to success during those years was to do nothing. The best approach was what’s called “passive” investing. The very name sounds like an assault on everything Men’s Fitness readers stand for, but look at the track record. Imagine you had the incredibly bad timing to start investing on January 1, 2000, right as the bull market was about to peak. Not trying to time the market or predict winners, you passively invested in broad indexes of U.S. and international stocks, and the U.S. bond market. Assume the standard allocation of 60% stocks and 40% bonds, rebalanced annually. The total return through August 31: 82.4%.
Please pause for a moment to reflect on that profit. An investor who plunked down $100,000 when the stock market was outrageously overvalued and just let his money sit there during an epic collapse of the global financial system now has $182,400. Whatever the next 13 years has in store for us, that passive port- folio is the way to invest. Here’s why it performed, and should continue to perform, so well.
You own everything
By owning three funds—Vanguard Total Stock Market (VTSAX), Van- guard Total Bond (VBTLX), and Vanguard Total International (VTIAX)—you own virtually all the stocks in the U.S. market, much of the bond market, and a broad selection of stocks from developed and emerging markets in the rest of the world. During the “lost decade” this portfolio did well, in part because while even pets.com was going belly up, bonds, international stocks, and small (non-tech) company shares held up fairly well. I don’t know what the savior will be in the coming years, but that’s the beauty of this portfolio: I don’t have to.
You keep more
These three funds charge an average fee of about 0.1%. That’s one dollar for every $1,000 invested. The average mutual fund charges about $13 per $1,000, and many charge far more. The difference may not sound like much, but in a year when you gain 5%, it amounts to nearly 20% of your return. Compounded over the decades, the extra gains really add up. A 30-year-old couple with a $100,000 portfolio would earn an extra $500,000 by retirement just by investing in the lowest-cost funds.
You get the total return
One common mistake is to assume that the numbers you see in the headlines rep- resent investors’ profits. In fact, thanks to dividends, investors can, and should, do better. The stocks in the S&P 500, for example, yield around 2%. So if you see that the S&P 500 is up, say 10% for the year, your total return should actually be 12%, minus expenses. This mistake is so widespread that Allan Roth, a Colorado financial advisor, believes money managers cite the index return without dividends to make their performance look better by comparison. Reinvested dividends account for 40% of the stock market’s return over the long term. Make them work for you.
You buy low and sell high
One of the keys to boosting your index- fund returns is to rebalance. In a year such as this one, when stocks do well and bonds do poorly, the 60/40 allocation in your portfolio will change to, say, 64/36. To get back to your target allocation, trim your stock position and add to your bonds. It feels crazy dumping winners and buying
losers, and it’s not easy to muster the discipline. So switch to autopilot. Some brokerage and 401(k) accounts will let you set up automatic rebalancing. Every year, you’ll be buying low and selling high.
You don’t have a crystal ball
Perhaps the greatest myth is the idea that the smartest guys can figure what the market is going to do and invest accordingly. Yes, Warren Buffett has done it. But can you name three more Warren Buffetts? In fact, Buffett has a million-dollar bet going with a hedge-fund manager that an index fund will beat the manager’s hedge funds. At last check, Buffett was winning.
Research has shown unequivocally that most stock pickers fail to keep up with the index over the long run. Each time they buy or sell a security, there are transaction fees. And after subtracting expenses— the money they spend on analysts, office space, paper clips—active money managers really get crushed. I will concede that, on rare occasions, the market serves up opportunities, and by making a bold move you can occasionally profit. But just as it would be foolish to try to build huge shoulders if you have a weak core, don’t try to outsmart the market until you’ve got the basics covered. And investing in index funds is a lot easier than upright rows.
Few comparisons illustrate the superiority of index investing as starkly as hedge-fund returns. Under SEC rules, you aren’t even allowed to join the hedge-fund club unless you have a million dollars in investable assets. It’s such a great club that guys pay the managers 2% a year in fees, plus 20% of profits just to be allowed in. So how have they done recently? According to hedge-fund tracker HFR, a broad index of hedge funds has returned an annualized 4.89% over the past five years. Roth reports that the 60/40 Vanguard portfolio has returned an annualized 8.01%. So for one-tenth of 1% you can earn more, or pay two and 20 and do worse. Your call.
One big disadvantage to an investment portfolio that consists of three boring index funds: At parties you can’t brag about your hot stock picks or your hedge- fund manager. So if anybody asks, just say your approach to investing is to play a zone. People love football metaphors.
Jack Otter is the author of Worth It...Not Worth It? Simple & Profitable Answers to Life’s Tough Financial Questions.
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