[Be clever. Index.]
While I love talking about stock picks and gut investing, this type of investing is not where most of your money should be. Picking stocks is gambling, it is way too risky for your savings!
So how and where should you be investing? In index funds, no doubt. Index funds track the market by owning a bit of all the stocks. So if the market goes up, the index fund goes up. This tracking of the market is done by a computer algorithm with little to no human input, making them passively managed. You can choose from a fund that tracks the entire Standard+Poor’s 500 (the 500 leading companies in America), a fund that tracks the Wilshire 5000 (all publicly traded companies in America), or a fund that tracks a subset of the market, like international bonds, or pharmaceuticals, or energy. You can pretty much find a fund for any market segment, or for the market as a whole.
Index funds are different than actively managed mutual funds in two big ways. One, index funds do not try to beat the market, they try to match the market. Two, index funds are passively managed by algorithms, versus actively managed mutual funds where the stocks are hand-chosen.
Why invest in an Index Fund? Two big reasons. One, because the vast majority (usually around 80%) of actively managed funds do not beat their respective indexes! This has proven true over decades of study (the first index fund was started in 1975), in both up and down markets. Two, with Index Funds you pay no commission (in finance-talk this is called no-load) and you pay a very low percentage fee on the money you invest (called an expense ratio).
So with an index fund chances are you will beat the return of an actively managed fund, while not paying a commission. And it turns out that fees matter – a lot.
Why are Index Funds so great? It’s easy to take them for granted now, but these are new and pretty revolutionary funds. Before Index Funds we were forced to pay high fees to invest with mutual funds that got lower returns than the market as a whole, especially once fees were considered. But then, inspired by many folk before him, the original indexer John Bogle came along. He founded Vanguard in 1974 and created the first index fund in 1975. He is kind of awesome and is a firm believer that costs matter. If you’re paying tons of fees your returns are going to suffer. He calls this, in the words of Louis Brandeis, being governed by the “relentless rules of humble arithmetic.”
[the rabbit is relentless and humble. and cute.]
How to invest in Index Funds? Go to Vanguard and open an account. Then look for index funds with no-load (remember this means you aren’t paying a commission) and a very low expense ratio (the percentage that you pay as a fee – it shouldn’t be higher than .4). Now continue to fund your account so you are buying gradually, and hold it so you don’t lose on transactional costs.
Think this sounds like investing for dummies? Think the top-dogs pick their own stocks or pay money managers to buy expensive mutual funds? Well, this is the exact same investment strategy as our friend Warren Buffet is setting out for his heirs. Yup.
And finally, one last quote to motivate you to listen to the studies and put your money in Index Funds instead of actively managed funds…from Brandeis’ 1914 book Other People’s Money that John Bogle pulled out about self serving financial management: