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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