“The grim irony of investing, then, is that we investors as a group not only don’t get what we pay for, we get precisely what we don’t pay for. So if we pay for nothing, we get everything.”
That’s a quote by John Bogle, who I’m sure is old news to you. In case you don’t know, he’s the man behind the investment giant, Vanguard. His ideal of low cost, accessible investing caught fire and continues to lead the mutual fund transformation taking place today.
What transformation you ask? Well of course, the one where investors wake up and embrace index investing. One where the masses stop going to brokerage houses to be sold a good story and an overpriced product. This is all happening right now, and you can join the movement.
Investing has a rather dark history that is clouded with high fees and outlandish commission based compensation models. Many individuals rely on investment advice from a “professional.” In reality, many of today’s financial advisors are just salesmen who push financial products. They make a nice profit while destroying the potential value of the investor’s portfolio.
Today I’d like to present a better way for the individual investor. A simple strategy that will allow you to outperform the majority of investors with very little effort. It’s called index investing and here are four reasons why it works.
1. Low Cost
This ought to be reason enough to embrace index investing. Study after study has proven that actively managed mutual funds under-perform index funds over the long haul. Those managers that appear to outperform an index show no persistence. Meaning they might outperform for a year, or three, but after 20 years, they’ve fallen by the wayside and have under-performed the comparative index.
The main reason for this under-performance is fees. Active trading requires managers and research and a host of other expenses which come directly out of the investors return. You pay for it, and you pay dearly.
For example, Vanguard has many index ETFs that can be bought for free with a 0.10 – 0.20% ongoing expense ratio. Many actively managed funds charge 1-1.5% ongoing expenses.
You can’t win paying 1% more in ongoing fees.
Another great reason to choose index investing is the diversification benefit. Investors should probably diversify as much as possible across U.S stocks, foreign stocks, bonds, REITs, and maybe cash. This is because these asset classes aren’t necessarily correlated. When one drops in value, another might increase in value.
It is extremely simple to buy the entire stock market for a very low fee through index funds or ETFs. Actually, you can have an excellent portfolio with just 3 vehicles – one for the entire U.S market, another for foreign equities, and a third for a mix of bonds. You’d own thousands upon thousands of companies with only 3 ETFs or index funds. Fantastic.
3. Tax efficiency
Both index funds and ETFs are tax efficient when compared to actively manged mutual funds. They have much less turnover – less buying and selling by nature. Active management involves an ongoing effort to buy underpriced securities and sell overpriced securities. This creates a multitude of taxable events for you.
If you only attempt to track an index, like the total U.S stock market, there is very little turnover. As a result, index investing is an excellent option in a taxable account. You’ll pay very little in year to year taxes.
ETFs are more efficient than index funds because you can control all capital gains. You decide when to buy and sell, so the only taxable event is dividend distributions. This is why I choose to own ETFs.
It’s very easy to understand that an S&P 500 index fund tracks the S&P 500 index. You know exactly what you are buying and you know that the returns will mimic the index. No surprises, no hidden fees, no loads. Just simple tax efficient investing.
Active management often brings all sorts of transparency issues into the mix. Because most actively managed funds under-perform their respective index, managers have to get creative about how the present the results. Or they have to start holding securities that are outside of the index in an attempt to find out-performance.
For example, a large cap mutual fund that has been under-performing the S&P 500, while charging 1% in fees, might start holding more mid cap securities in a desperate attempt to show some extra performance. This is called style drift and it happens quite often without investors being aware.
How To Start Today
For the DIY investor, I prefer Vanguard for most of my investments because you can trade ETFs for free. I’m also a fan of Motif Investing which allows you to pick up to 30 ETFs for a flat $10. If you just want to buy a single ETF, my choice is still Optionshouse where trades are $4.75.
If you aren’t yet ready to manage your own money, check out Betterment. For a management fee around 0.15%, they will manage all of your money and invest in well diversified Vanguard ETFs. They’ll also efficiently rebalance your portfolio and provide tax loss harvesting. It’s truly a great service for the price, but I’d just learn to handle it your own investments in the long haul.
There are other things I could say, but these four reasons should compel you to choose index funds for the majority of your portfolio. Do you have any additional thoughts?
Author Bio: I’m Jacob, one half of the Cash Cow Couple. My wife and I enjoy teaching others how to live an abundant life on a very modest salary. We are attempting to spend less than $12,000 in our first year of marriage because we truly believe that less is more.