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.

10 thoughts on “Two Rules of Investing

  1. ok, you are talking to a stock/mutual fund/index virgin. Most of what you typed was greek…if you could put it to a toddler…How much does one need to invest WISELY and what would you recommend (actual names n such). We truly need to diversify before we are left cold and hungry living in a cardboard box at 65! LOL money managers and “people” cost extra money that we don’t necessarily have. So in the wise words of some random actor ” ‘splain it to me like I’m a three year old.”

  2. I can’t tell you how much you’ll need to save, since that really depends on how much you guys are bringing in, how long until you’ll need the money, etc. The easiest thing to do is invest in a Vanguard Lifecycle Fund, like the Vanguard Target Retirement 2035 one. It’s all index funds, it has an expense ratio of 0.18%, and it automatically does the diversification and rebalancing I was talking about. The downside is that you’ve got to come up with $3,000 to open an account, and ideally you should be putting money in every month.

  3. Couple of addendums since you have once again meandered into my realm.
    Don’t forget the SPY and the DIA (aka the Spiders and the Diamonds)
    The SPY is a tracking stock listed on AMEX. It is a tracking stock based on the S&P 500 and basically can be bought, sold, shorted and margined.
    The DIA is the same thing for the dow 30. These are good ways to track an index without having to pay the fees associated with mutual funds.

    Another thing to look at is bonds. In a market like we are facing today AAA rated bonds (especially municipal and general obligation) are a very safe haven for money. If you are going to research bonds there are 2 key phrases that you need to look for. Non-callable and convertable. The non-callable piece basically means that the bond cannot be payed out early thereby killing your cash cow before its time has come.
    A 30 year bond (minimum investment of 10k) will pay you an interest payment every 6 months and then at the end of the 30 years the full original investment will be paid back to you. The coupons (interest payments) are generally set up as January/June or May/October and you will get x percent of your original investment back. The other thing is that some bonds will be tax deductable (such as municipal bonds) although those tend to be 10 year bonds.

    You can ladder bonds wherein you get a a coupon payment every month by getting a January/June, a February/July, a March/August, a April/September, and a May/October thereby insuring that each month a bond is paying off. Granted this is a large initial investment but the payoffs can be quite acceptable if you find the correct bonds then the long term payoffs are more than adequate.

    Just my .02

  4. Matthew: Yeah, we’re putting our non-401k retirement stuff in a Roth IRA.

    Jody: I’d hoped you’d show up! I hadn’t thought about addressing exchange-traded funds. I looked at VIPERs back in the day (or whatever Vanguard’s calling them now), but decided the transaction costs (given small monthly investments) and delayed dividend investment made index funds more attractive to me. Looking just now, I see that Vanguard’s ETFs have half the expense ratio of their index funds.

    I’d never heard of or thought about bond laddering. I’ve seen CD laddering before for cash investments. For bonds right now I’m just going with a bond index fund, since I don’t have huge sacks of cash to invest.

    Good info all around, and stuff for me to mull over.

  5. I picked up a book awhile back wherein Ben Stein compares various investment strategies, and he found that market timing (buy low, sell high) and monthly installments (always buy, never sell) were both beaten by buying low and never selling (over long runs against historical data). In time intervals that you don’t buy, accumulate the cash you would have invested for a larger investment when the metrics become favorable again.

    Buying low here is defined as buying when stock price * existing shares / (assets – debt) is less than a threshold. This is of course only applying to the aggregate statistics of a diversified fund – single stocks are far too ideosyncratic to evaluate that way.

  6. Did he have any examples of applying his metric for what low is? Because I’d be very interested to see how it fared in the current market implosion. My gut feeling is that “buy low” inevitably fails because there is no real way of measuring low — you can’t really tell when you’re near a local minimum in price.

  7. What you could argue, Stephen, is an estimation of future earnings expected and check the P/Efut. But that’s ballsy. Of course, that’s the reason that you choose to invest in one stock over another: expectations of future dividend earnings being available at the strike price at the time you buy. Yes, that goes against all your advice, but it also goes back to the fundamentals of what investors should be trying to do, including the institutional ones, instead of this short-term, leveraged-to-the-hilt crap. But that’s a rant for my blog and not yours.

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