Two Rules of Investing

Since the economy’s doing so well, let’s talk investing! Everything I know about investing in stocks and bonds can be boiled down to two rules.

1. Buy index funds.
2. Diversify.

To understand index funds, you have to know what an index is: a collection of companies or bonds that someone tracks to get an idea of how the market is doing. Standard and Poor’s 500 Index is one of the best known by virtue of its age. It takes 500 large companies listed on the New York Stock Exchange and combines their stock price and number of shares to create a single number. But there are lots of other indices, such as the Russell 2000 that tracks small companies, or the Wilshire 5000 that tracks almost all of the NYSE stocks. At its simplest, an index fund buys all of the stocks listed in one of these indices and holds them. It’s a form of investing called passive investing, and is exciting as a bowl of dirt. There’s not any real buy-and-sell action, and you can’t beat the market with an index fund. The best you can do is get a return that matches the index.

Why index funds? Why not individual stocks? What about actively-managed mutual funds, where fund managers are buying and selling stocks to try to beat the market’s average return? I gave up on buying individual stocks early because I suck at picking stocks. I don’t have a lot of time to research companies, and even if I did, I’m going up against all of the mutual fund managers and other investors whose full time job is researching companies. Me buying an individual stock is like me betting on the ponies. I’m putting money into a company hoping the company’s stock value goes up.

That leaves actively-managed funds. As one financial advisor explained to me, if you buy an index fund, you’re spending the most on the stocks that are the most expensive. Wouldn’t you be much better off spending more on cheaper stocks so that, if they go up, you get a much greater return?

The problem is that mutual fund managers don’t actually do that very well. Getting the market’s average doesn’t sound exciting, but how many mutual funds meet even that modest goal? It turns out that most fund managers don’t beat their benchmark index, and they have no real ability to time the market. And even if they do beat their benchmark in one year, there’s little evidence that they can continue to do so over the long run.

It gets worse, though. Every mutual fund charges ongoing fees, expressed as the fund’s expense ratio. Every year, a percentage of the fund’s assets go towards paying the fund managers, paying the research team, paying for marketing, and so on. Those annual fees handicap a fund’s returns right out of the gate. For instance, if a fund has a return of 5% one year and its fees are 2%, the real rate of return is 3%.

In 2007 the simple average of stock funds’ annual fees was 1.46%, though individual fees can go much higher. Index funds, on the other hand, have extremely low fees when done properly. For instance, Vanguard’s 500 Index Fund has an expense ratio of 0.15%. That means your average actively-managed large-company fund has to be 1% better than the market average to beat the Vanguard index fund. And the actively-managed funds can’t even beat the average most of the time!

So why not just buy a single stock index and be done with it? Because you may need that money at a time when the stock market is in the tank. Ideally you’d have some investments that perform well when others are doing poorly. What you’re looking for is a set of investments that are uncorrelated, so that the performance of one is unrelated to the other.

That’s what diversification attempts to do. Instead of holding a handful of stocks, or just some bonds, hold different groups of assets. You should at least own a mix of US stocks (both in large and small companies), bonds, international stocks and bonds, and cash. You sacrifice some potential gain (but not much!) in return for greatly reducing how much your portfolio’s value will fluctuate. And the costs of not diversifying can be dramatic.

What’s tricky is deciding how much to put into what investments — what your asset allocation should be. There are various calculators to help you decide, like the Iowa Public Employees Retirement System’s. But once you’ve set your allocation, don’t fiddle with it. Trying to time the market will cost you a lot of money. Instead, do two things. One, invest systematically. A smaller monthly investment is much better than a yearly lump sum or, heaven help you, trying to time the market. Two, once a year you should rebalance your portfolio. Some of your investments will do well (or at least less poorly) than others, so your percentage of money allocated to different assets will change. Sell off the winners and reinvest in the losers to bring your percentages back in line with your goals. It sounds stupid, but what you’re doing is buying low and selling high.

There are myriad tweaks you can make to those two rules, but they’re where I would start. They won’t guarantee that you’ll always make money, or protect you as the global financial markets merrily burn, but they’re better than just about any other current approach.

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