Investing 101, Part Three: Diversify, Diversify, Diversify (Cheaply)

i101pt3Last time, we talked about why you need to invest and how to keep from paying hefty taxes on your investments. Let’s finally talk about how to choose the investments themselves. There are several different types of things to invest in. Let’s go over the two big ones:

  • Stocks, sometimes referred to as “equities,” are pieces of ownership in a company. The stock market is fairly risky, but also has huge potential for profit.
  • Bonds are loans that are made to governments from local to federal levels. These are viewed as a conservative investment. Since they are traded relative to interest rates, they are much more stable than a stock.

Owning a single stock or bond is fairly risky. A company can go out of business, and a government can go bankrupt. That is why there is one simple rule:

Diversify, Diversify, Diversify

We can mitigate our investment risk by holding many different types of investments, or diversifying. We want bonds from many different governments to protect ourselves from a single government defaulting on their repayments, and stocks from many companies to prevent losing all of our money if a single company goes out of business. For an individual, though, accumulating this collection would be really time-consuming. Having to choose, purchase, and sell investments doesn’t sound fun to me, and I love this personal finance stuff. Fortunately, there’s a type of investment that does this for you, called a mutual fund.

A mutual fund pools money from many investors, using it to buy a collection of stocks, bonds, or even real estate. They are managed by a fund manager, who picks the investments that go inside the fund. You, as the investor, buy shares of the fund, which is a piece of ownership of the investments inside the fund. Basically, a mutual fund allows you to not put all of your eggs into one basket. Because of their diversity, mutual funds are, in my opinion, the only way to go for a starting investor, who has the most to lose from their investments going awry. Just understanding the basics of the need to save and figuring out that your money needs to be diversified so as not to lost it all will put you miles ahead of most people.

Let’s pause here, then. One really, really easy, way to invest for retirement for someone who wants to pick an option and never think about it again, would be to invest in a target retirement date mutual fund. This is a collection of funds managed by someone who re-balances and shifts the investments inside to make them appropriate to someone at your assumed age, based on your target retirement date. So, younger people have riskier investments and older people have more conservative investments without the investor ever having to make any changes themselves. Most employers offer target date options as a default option in 401k plans these days, and there are also many options for IRAs.

Is my money in a target retirement date fund? Nope. It’s fine if having to think about this stuff is really awful for you. For a little more work, though, I feel like I can probably obtain a similar or better return and create a set of investments that matches the exact level of risk that I want to take. If that’s something you might be interested in doing, keep on reading.

Fees Really Matter

Assuming that two mutual funds contain the same type of investment (i.e. broad types of stock or bonds, called “asset classes”), the #1 predictor of how well a fund will perform over time is its expense ratio, or how much it costs to run the fund. These expenses are the fees paid to the fund managers and any organizational costs. It will typically be a number somewhere between .5% and 2.5%. Since that range of numbers is so small, the expense ratio shouldn’t make much difference, right?

Morningstar is a company that uses a star system to rate how successful they expect a mutual fund to be. They’re a company whose entire job is to predict investment performance, and they’re pretty much the industry standard. They recently ran the numbers and guess what: expense ratios were a better predictor of the overall return of a mutual fund than their rating system in every single asset class. Why? Let’s say you put $100,000 into two mutual funds that have the same investments inside, but one fund charges 2% more in fees. Paying 2% more in fees means you’re paying $2,000 a year to have the fund with the higher expenses, or $20,000 over the course of ten years. Of course, the caveat is that typically we’re not perfectly comparing apples to apples–the funds might not have the exact same investments inside. Just remember, though, that the more expensive investment would need to perform $20,000 better over ten years just to break even with the index fund.

This is why index funds are the bomb dot com. (Do people still say that? No? Okay.) Index funds are mutual funds in which the investments are selected according to a set rule. Typically that rule is to model a stock index as closely as possible. A stock index is a list put together to track the performance of a piece of the stock market. The S&P 500 is an example. Because the fund simply has to match a rule (and computers can be enlisted to make that happen), the fund managers can charge a whole lot less in fees. One popular investment strategy (and the one I use) even claims that you can outperform most people simply by using index funds to invest in the entirety of the stock market.

Wait, isn’t that nuts, though? Aren’t we supposed to be investing only in the winning parts of the stock market, so that we can “beat” the market?! And to that, I say, meet my friends Ferri and Benke. They did a study, replicated many times since, in which they compared the performance of regular managed funds against index funds. The best case scenarios for the managed funds were those in which the index funds were pitted against the managed funds with the lowest expenses, which is to say the funds where the managers got paid the least. (This is another proof that expenses really matter.) Even in that scenario, the index funds won 71% of the time. Moreover, the longer you extended the period under review, the more likely the indexes were to win. Even if the managed funds won for a ten-year stretch, the same fund struggled to beat the index for the next ten year period.

All of that is to say, there’s no real way to predict the market, or at least not for long. Managed funds pay “experts” a lot of money to do it, but they still can’t consistently beat the index in their own asset class. Meanwhile, the stock market as a whole has grown an average of 8% per year (with ups and downs). If you’re paying essentially no fees out of that, you’re looking at an 8% return on your money from investing in the entire stock market. This is why I think index funds in which you can replicate the entire market are the way to go.

So how exactly do you establish a total market index fund portfolio? We’ll talk about that next time, when we discuss the second most important part of managing your investments: asset allocation.

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