Historically, the stock market has been a tremendous wealth building machine. On average, it has returned roughly 10% per year since it's inception. For new investors, there are always a lot of questions. How much risk is involved? How much money do I need in order to invest? And, most importantly, what should my investment strategy be?
There are a number of web sites, books, magazines, and people who claim to have all the investment answers. They supposedly know exactly how to become a millionaire overnight. And they'll sell it to you for a low low price of $19.95, plus shipping and handling. There are more of these people than you think. Some of them even have titles, such as 'financial advisor', or 'investment guru'. Some of them even have their own tv shows, where they shout out their opinions on various stocks and companies.
One of the things you always have to ask yourself is, if these gurus know the path to wealth, why are they selling this path to you? If they already know the path to riches, why is it that they are only getting rich off of selling this 'system' to other people? The answer is simple. They don't know how to become rich. If they did, they would already be rich. They wouldn't be getting rich by selling this 'path' to others.
Many of these lies, however, are spread so much that they become 'common knowledge'. So now there is a vast plethora of investing information, both good and bad, which makes the whole field feel very intimidating for new investors. They feel that they need all kinds of specialized knowledge and schooling in order to be a successful investor. In reality, you don't need very much true knowledge to become a successful investor. You don't need to read hundreds of books, nor do you need an MBA from Harvard. The point of investing isn't to work for your investments, but rather, to let your investments work for you. Allowing other people to work for you doesn't require much knowledge on your part.
This course is about practical investing. It isn't about chasing hot stocks, making emotionalized decisions, or playing the market. This course does not cover technical analysis of stock prices. Nor does it cover fundamental analysis of companies. The reason for this is simple. For the average investor, investing in individual stocks involves too much risk. It is more akin to gambling than investing. Companies, no matter how big they are, or how long they have been in business, are not immune to failure. If your portfolio involves only a few companies, and one or two of them fail, this could easily spell financial disaster for you. It isn't worth trading in the guarantee of significant risk for the potential of significant reward.
I'm going to further emphasize this point, because I know that someone is going to read this and still decide that investing in individual stocks is a wise decision to make. I work as a software engineer, have two college degrees, and have enjoyed academic success my entire life. I work alongside several mechanical, chemical, and manufacturing engineers. Several of my friends graduated at the top of their class. According to many IQ tests I am a 'genius' or 'near genius'. I have never once met anyone in my personal or professional life who has beat the market for more than a decade by investing in individual stocks. This includes myself. Not a single person. The kind of mind that is required to enjoy stock picking success is different than the kind of mind that enjoys academic success. Just because you have a high IQ, or some college degrees, doesn't mean that you will be good at trading stocks. If after reading this you still have a desire to trade individual stocks, I strongly urge you to go setup a practice account where you can use virtual money to trade stocks, and record how well you do. A very smart man once told me the same thing. I ignored him. That was the most expensive lesson I've ever learned.
In order to invest in the stock market while minimizing your risk you can diversify your holdings by buying into stock funds. Many of these funds contain hundreds, if not thousands, of stocks. As the price of one stock is going down, the price of another stock will(hopefully) be going up. This results in less volatility in your portfolio and a smaller risk of significant failure of any one part. An index can't declare bankruptcy.
You can further diversify by including large, medium, and small cap stocks, as well as international stocks. Some people will argue that international stocks are unnecessary. Others will argue that domestic stocks are unnecessary, and you should only include international stocks in your portfolio. This is largely a matter of opinion, as no one truly knows whether domestic or international stocks will outperform the other in the coming decade. It's best just to hold both.
There are two primary kinds of stock funds. Actively managed mutual funds, and passively managed index funds. The primary difference is that actively managed mutual funds have a manager or team that chooses when to buy, sell, and hold stocks. Passively managed index funds are usually tied to a particular index, and they buy, sell, and hold their stocks in order to best replicate the performance of the index.
Besides stock funds, you can also purchase other types of funds. For example, you can purchase bond funds that hold a variety of different kinds of debt instruments. Bond funds are less volatile and are generally considered to be less risky than stock funds, although some people may argue this point for really long term investments. The cost of this minimized risk comes in the form of decreased performance. Over decade long time spans, bond funds seldom outperform stock funds. You can also purchase real estate funds, commodity funds, hedge funds, etc. The list is endless, and growing by the day.
Once you've decided that you don't want to spend your days trading individual stocks, and have familiarized yourself with the different kinds of funds available to invest in, you are left with one basic question. Which funds should you invest in, and how much should you invest in them? This is the one question that people tend to spend the most amount of time on. So let's consider our options.
First, should you invest in actively managed mutual funds, or should you invest in passively managed index funds? Many people like the idea that they are entrusting their money to a manager or team of professionals. It makes them feel safer, knowing that an actual person is making decisions about what to do with their money. But is this really the best choice to make? Let's examine...
The stock market as a whole is comprised of several thousand different stocks, both domestic and foreign. These stocks represent companies of all shapes and sizes, engaged in every kind of business imaginable. The job of a mutual fund manager is to pick the stocks that are most likely to outperform the others in the foreseeable future. There are literally millions of different people who are examining these stocks. Day traders, mutual fund managers, financial advisors, investment gurus, financial analysts, amateur traders, and mutual fund manager assistants, to name a few.
An index fund, by definition, tracks the average return of a segment of the market. Since the index is the average, roughly half of the mutual fund managers should do better than the average, and half of them should do worse, assuming everything else is equal. But everything else isn't equal.
There are a couple things that stack the deck against you when you invest in actively managed mutual funds. First, actively managed mutual funds have higher expense ratios than passively managed index funds, usually in the 1.5% range, whereas many index funds are around the 0.3% range. This means that for the average mutual fund to even match the index return, it has to return 1.2% more than the market does. If half of mutual fund managers are above average, and half are below average, and you then increase the return that is required to be average by 1.2%, this has the effect of reducing the number of mutual fund managers that can even hit the average mark in any given year to below 50%. Your odds of picking a winning mutual fund are now against you.
Furthermore, mutual fund managers are human beings, subject to making mistakes, and the market is mostly erratic and driven largely by human emotion and perception anyway. The semi random nature of the stock market combined with inconsistent mutual fund managers make it difficult for even the best managers to consistently beat the market year after year. Certainly, there are managers that will beat the market every now and then. The issue is one of replication.
This line of reasoning is backed up by countless academic studies that show that the typical mutual fund fails to outperform the indexes. Just like with individual stock picking, trusting your money to a mutual fund manager will yield a very small possibility that you may beat the market, but it also exposes you to a tremendous amount of risk that you won't beat the market. The longer investment time horizon you have, the higher the probability is that your mutual fund will fail to beat the market during that time period.
So the reasonable choice is to just invest in an index fund. Don't fall for the hype. Take the guaranteed, above average return, and run with it. You'll be glad you did.
No one truly knows what the future holds. So I can't just say, here is the guaranteed best portfolio for your exact situation, because that would involve knowing what the future holds for you as well as for everyone else on the planet. At best, I can make an educated guess as to what the ideal portfolio is by looking at the historical performance of different portfolios.
In order to provide the best portfolio, I also have to know what kind of investment goals and objectives you have. Are you looking for a portfolio that will net the best possible return for the long term? Do you want a portfolio that will provide you with a decent amount of income? How much risk can you tolerate? If the value of your portfolio dropped by 30% tomorrow, would you panic and sell? These are questions that only you know the answer to. In order to figure out what kind of portfolio you need, I'm going to list five possible descriptions. Please choose the description that fits you best.
| 1 | 2 | 3 | 4 | 5 | |||||
| VTI | 60% | VTI | 56% | VTI | 40% | VTI | 35% | VTI | 28% |
| VEU | 30% | VEU | 24% | VEU | 20% | VEU | 15% | VEU | 12% |
| VB | 10% | BLV | 20% | VNQ | 20% | VNQ | 20% | BND | 20% |
| BLV | 20% | BLV | 30% | BLV | 40% | ||||
All 5 of these portfolios consist of low cost Vanguard Exchange Traded Funds. For the most part, these portfolios can be replicated using index funds from Vanguard, Fidelity, or T. Rowe Price. The important part is to keep the management costs to a minimum. The lower the costs are, the more money you get to keep.
This is the reason why all of these portfolios use ETF's. Over the long term, the lower costs of the ETF's should enable them to beat out their index fund companions. There is a down side, however, in that you have to purchase ETF's using a stock broker, who will usually charge a per trade commission. If the commission is too high, and your purchase amount is too low, this may negate the cost savings of the ETF's, even over the course of several years. In order to effectively use ETF's, it's best to keep the commission under 1% of your total purchase amount, and then to keep the ETF's for a decade or more. Otherwise, it would likely cost less to just use plain index funds.
Re balancing your portfolio annually or semi-annually has been shown to raise the overall return of your portfolio. The reasoning behind this is fairly simple. Many asset classes aren't closely correlated with each other. Bond and stocks, in fact, tend to move in opposite directions. As the price of stocks drop, investors flee to the relative safe haven of bonds, and vice versa. By selling the gains of one ETF and buying into the losses of another, you can take advantage of trading volatility.
If you're constantly investing in the stock market, another way to re balance your portfolio is to buy the losers. Whenever you go to make a new purchase, simple buy the part of your portfolio that is furthest away from the percentage that it should be at. This results in a continuous re balancing of your portfolio. If your portfolio percentages get too far away from normal, however, you may still need to fall back to re balancing your portfolio annually or semi-annually.
The stock market is a tremendous wealth generating tool. It isn't for everyone, however. When I first got into investing, I read several books, web sites, magazines, and did a lot of personal research. I invested $16,000 dollars into individual stocks which I considered to be undervalued. In less than a year, I had lost half of this money. The economy was starting to sink into a recession when I first started - a fact that I was blissfully unaware of.
During this time I spent countless hours researching stocks and companies, looking at income statements, cash flows, and balance sheets, all the while reading books and magazines on investing and making trading decisions. Investing became a part time job. Not only did I lose half my money, I lost half my time as well. The following year I switched to portfolio #3. I spent a few minutes every other week deciding which ETF I should purchase. My portfolio returned 20% in the first 6 months, and continues to do well today.
If I could go back in time, I would give my past self one piece of advice. You shouldn't work for your investments. Your investments should work for you. The companies that the stock market represents are full of executives, managers, engineers, marketers, sales people, accountants, customer service reps, employees, contractors, and common laborers. Let them work for you.
Investing always involves risks. One of the most common mistakes that people fall for is staring at the sky as they fall from the airplane. They're so busy focusing on maximizing their potential reward that they forget about the risks involved. The ground is a rude awakening for such people. Instead of shooting wildly at an unachievable dream, aim deliberately for an achievable goal. And remember to pack a parachute. Just in case.
Many people believe that your active focus, attention, and energy is required in order to be successful at any given activity. Investing is quite the opposite. This is one of the reasons that many people fail at investing. They turn it into another game that they have to win at. It progressively becomes less and less about investing, and more and more about gambling. They never understand the fundamental point. Investors don't make money off of the amount of trading activity that they do. Investors make money because their investments are creating value for them. The whole point of investing is to get someone else to do the work for you.
Of course, I'm not complaining about such people. Their frantic nature promotes volatility in the stock market. Volatility in the stock market promotes the performance of my portfolio. So if you want to gamble in the market, by all means, go for it. Don't let me sway you into making the wrong decision. [grin]