Index investing is by far the simplest way for most of us to build wealth. Compared to other viable investing strategies, index investing has lower costs, lower risks, and higher returns. Plus, it requires almost no management: just invest, sit back, and forget about it. What’s not to like?
Unless you are a multi-millionaire, you most likely cannot do better than index investing. Anyone who tries to convince you otherwise is either misinformed or, more likely, is trying to make you part with your hard-earned money.
What Is Index Investing?
Index investing simply means investing in mutual funds or exchange-traded funds (ETFs) which consist of all or substantially all of the stocks in a given market index, such as the S&P 500. Index funds own all companies in an index: the good, the bad, and the ugly.
The opposite of index investing would be active investing, in which stock traders try to pick what they think are the best stocks, and avoid the others. An index investor doesn’t care about picking winners and losers, or making bets. An index investor just invests, and lets the market do the rest.
Index Investing Out-Performs
The biggest secret on Wall Street, is that all the highly-compensated, brilliant stock traders and financial advisers with nicely-pressed cuffs, big beautiful cars, and fabulous ivy-league degrees, on average cannot out-perform market index funds.
In fact, actively managed funds reliably perform worse than index funds due to their higher costs.
Yes, there are many active traders who beat the market one year, or perhaps even a few years in a row. But research indicates that this may be nothing more than pure luck. I would argue that there are some people and algorithms that are smarter than the rest of us, and can out-perform the market. The problem is that they charge too much.
Don’t Be Fooled By Survivorship Bias
Here’s a Life Pro Tip for you: if something stinks like shit, stay away. “Survivorship bias” refers to a trick that actively managed investment companies commonly use to select their results so they appear better than reality. Here’s how it works: Each year, start 20 new actively-managed mutual funds. After 1 year, close the lowest performers, and keep the highest-performers open.
Do the same thing the next year and the next year. After a few years, you will have a few funds that actually beat the market several years in a row. The success of those funds may be due to nothing more than pure random luck, but that’s not what you tell your clients. When you go market these high-performing turds to your clients, tell them that you know exactly what you’re doing (you do), and that you deserve to get paid super-high management fees (you don’t).
Final touch: add a disclaimer that “past performance is not indicative of future results.” That way your clients can’t sue you for fraud when your funds’ luck runs out. By then, you’ll have another “successful” fund to show them anyway.
Life Pro Tip: If something stinks like shit, stay away.
High Costs = Low Performance
The main reason index investing is more successful on average than active investing is simple: lower costs. Because index funds don’t need to pay high salaries for those Hampton’s pedigrees, index funds usually keep their administrative costs much lower than active funds. The lower administrative costs directly result in higher average performance. If you are an investor, that means more money in your pocket.
In other words, folks with fancy post-nominal titles and ivy league degrees can and do consistently beat the market because they are smarter. The problem is that they charge too much for their services! They charge so much, that any out-performance is more than offset by their fees. Investment advisers tend to keep the winnings, not the investors.
Index funds don’t try to beat the market, they just try to minimize their management costs.
The Best Single Investment Anywhere
If I had only one place to put my money, this would be it: The Vanguard Total Stock Market Index Fund (VTSAX), or it’s ETF equivalent (VTI). This fund invests in substantially all publically traded companies in the US, with management fees of only 0.05% per year. This means if you have $100,000 invested in this fund, you will pay a mere $50 per year in management fees. Not bad for owning thousands of underlying stocks.
Diversification is the only reason I own any other investments at all.
Can You Do Better?
Yes you can. People can and do outperform index investing all the time, and they do it consistently. But paying someone else to do it is consistently a losing proposition, unless you’re already rolling in it.
There are two ways that you can beat the market. Your first option is to create your own actively managed portfolio of individual stocks, although this is fraught with risk. The second is to be a multi-millionaire who can access great advice without paying too much for it.
When To Buy Individual Stocks
Buying individual stocks is fun. It takes work and it takes knowledge if you want to do well. It also involves a number of risks that don’t exist with index investing. I like to dabble in individual stocks for fun/entertainment (index investing is boring, after all). But I keep it below 5-10% of my total portfolio in order to avoid being too exposed to the additional risks.
I like to think I’m smart, but I don’t have the hubris to think I can beat the smartest people and best algorithms on Wall Street.
One of the many risks of investing in individual stocks is the risk of paying too high commissions and fees. If you are only investing $1,000 in an individual stock, and you pay $5 to trade in and out, you’ve just paid a 1% commission on the stock.
I’m not OK paying such a high commission – it really eats into your returns. With individual stocks, you can easily run into the same problem we have with actively managed mutual funds: the fees are too high.
If you’re going to invest in individual stocks, you need to find a way to do it at low cost.
The high commissions and fees has long been the biggest deterrent for me to buy individual stocks. Today, there are far better options than there were twenty years ago.
In 2016, I joined Robinhood, which is a mobile-only trading platform that actually charges no trading commissions on most stocks. It’s a great, no-frills way to buy individual stocks. You’ll have to do your own research and analysis, but Robinhood really represents a new paradigm for individual stock investing. The lack of trading fees opens up all kinds of possibilities. More on that in a later post.
When Index Investing Becomes Too Expensive
Even my favorite mutual fund, the The Vanguard Total Stock Market Index Fund (VTSAX), can get too expensive if you have a ton of money in it. Since all mutual funds and ETFs charge a percent management fee, the more money you have in a fund, the more you pay for the same management service. If you have $10M invested in VTSAX, you will be paying $5,000 per year, every year, for what is effectively auto-pilot investing.
More likely, VTSAX will not be your only mutual fund. In order to take advantage of the benefits of diversification, you should have some money in bond funds and international funds, and possibly others, like REIT funds, as well. Across my portfolio, my average management fees are 0.12%. Someone with $10M in the same portfolio as me would be paying $12,000 per year.
While that is much much cheaper than just about every mutual fund out there, but you can build your own index portfolio of individual stocks that effectively tracks the market, or even an actively managed portfolio, for much much less than $12,000 per year. This is where it can become more effective to pay a flat fee (not a commission) to some brilliant Wall Street advisers who can help you beat the market.
For the rest of us who are not multi-millionaires, index funds with minimal costs are our best investment choice.