If you think about it, a lot of dollar cost averaging happens automatically. The most common example is having an employer put money from every paycheck into a retirement plan. These investments are made regularly at the same interval as the paychecks. At the other end, having money taken out of your plan and sent to you monthly will achieve the same effect: diversifying over time.
Use Index Mutual Funds to Create Very Broad Diversification
At first glance, it would seem difficult to construct such broadly diversified investment portfolios. They require investing in hundreds of individual securities in complex combinations. Furthermore, holding so many different individual investments would require more capital than most of us have. It would also cost a significant amount just for trading fees. As argued earlier, though, mutual funds and their progeny3 have made this task quite easy. The desired diversification can be achieved by investing in just a handful of funds.
A vehicle that allows you to invest in hundreds of stocks with a single investment is just what the diversification doctor ordered. You can easily gain complete exposure to all of the asset classes and subclasses discussed here.
Once it is clear that mutual funds and their cousins4 are the way to achieve your diversification goals, the question becomes what sort of mutual funds you should invest in.
Funds that are actively managed involve someone (or a group) running the fund and aggressively trying to decide which investments are best. At their worst, actively managed funds trade in and out of stocks often and generate large trading commission costs. They are expensive to operate—which cost is passed on to shareholders in a slightly clandestine way as operating expenses. They also create capital gains, if they are lucky, or capital losses that must be declared as taxable events. At their best, actively managed funds buy good stocks, trade only occasionally, and have expenses only double or triple those of the best index funds.
Index funds, on the other hand, skip the cost of having someone pick out individual investments. Rather, they buy all the stocks in a given index (such as the Standard & Poor’s 500) in their correct proportions and accept the fact that they will perform no better than that index.
The Efficient Markets Hypothesis
The efficient markets hypothesis shows us why index funds are the wiser choice.5 There has long been a great debate in the investment world regarding active versus passive funds. One of the fundamental contentions of this book is that the indexers are right, the active management crowd is mistaken, and the stakes for an investor are very significant.
If nobody can know in advance which stocks or investments will do better or which mutual funds will succeed in picking the best performers, it makes more sense to simply choose the index fund and accept the advantage of its extremely low costs. And because actively managed funds incur much higher costs, they have little hope of outperforming index funds over long periods. Index funds allow investors to play the odds the prudent way by holding investing costs to a minimum, being tax savvy, and acknowledging that there is no effective way to beat the market. They are the wisest method for pursuing your investment aims.
When comparing index funds, you can include exchange-traded funds (ETFs) in your research. These investment vehicles are, essentially, index funds that trade throughout the day like stocks. Because they were created to compete with index funds, they have extremely low operating costs, in some cases even lower than comparable index mutual funds. As a result, they are a valuable complement to traditional index funds and, notwithstanding all the hype, a worthwhile investment vehicle.
Some Practical Advice on Choosing Specific Categories of Index Funds
Some of you have picked up this book looking for specific and practical advice. This paragraph is for you. A good suggestion is to invest in a total U.S. stock market index fund and a total international stock index fund. To these you may wish to add an emerging markets stock index fund. With those three index funds, you will own a slice of the overwhelming majority of stocks that trade in the world. For bonds, use a total U.S. bond index fund, and supplement it with a foreign bond fund. For real estate, look for a U.S. REIT index fund and an international REIT index fund or a combined global REIT index. For inflation-protected bonds (TIPS), a number of fund companies offer these unique bonds. Finally, if you want to invest in some hard assets, consider a precious metals fund and a natural resources fund. Many investors access commodities by choosing funds that invest in the companies that mine or sell them. If you need something to hold in your hands besides your monthly statement, you may want to buy a few Canadian Maple Leaf gold coins and some pre-1965 U.S. dimes, quarters, and half-dollar coins.
In sum, you should have a portfolio of mutual funds that invest in all sectors of the U.S. and foreign stock markets in proportion to their overall market capitalizations. You should also hold funds that invest in the various types of bonds. Through other funds, you should add investments in foreign bonds, Treasury inflation-protected bonds, and diversified real estate. You may also consider a small fund investment that targets hard assets or precious metals. Almost all of these can be achieved through very-low-cost index funds (or ETFs), and that is usually the wisest choice.
Chapter Summary
Consider stock investments only for long-term investments.
Invest across all the recognized asset classes.
Invest over intervals of time (rather than all at once) to further reduce risk.
Build a diversified portfolio by using low-cost funds or ETFs.
In most circumstances, choose index funds rather than actively managed funds.
Avoid paying anyone to pick individual stocks and bonds—either directly or indirectly.
Notes
1. Jeremy Siegel, Stocks for the Long Run, 5th ed. (New York: McGraw-Hill, 2013).
2. Beverly Goodman, “Back to School: Fama, French Discuss Their Work,” Barron’s, January 4, 2014.
3. Mutual funds and more recently developed investment vehicles that share their characteristics and low costs. See comments in the next section that take favorable notice of ETFs.
4. Throughout this book, when I refer to index mutual funds, I am talking about all the investment vehicles that perform like those funds and have equally low costs. For example, I have referred to an investment that allows you to own a small slice of many stocks or bonds as a mutual fund. For many of us, though, much of our portfolio is held in tax-deferred vehicles such as a 401(k), IRA, or other pension plan, or a 529 or Education-IRA college savings plan. Such tax vehicles use different terminology for the same idea. Thus, your 401(k) may allow you choices that are extremely similar to (or the same as) a mutual fund company’s offerings, but they go by different names. A rose is still a rose (and a dog remains a dog) regardless of the label, so you should use the logic of these chapters in the same way for your tax-deferred plans as for your normal (nonretirement) investments.
5. Eugene Fama, “Efficient Capital Markets: A Review of Theory and Empirical Work,” Journal of Finance 25, no. 2 (May 1970): 383–417.
Chapter 32
We Know What Has Happened in the Past
There’s no mystery to past performance of investments that trade on major exchanges. Research tells us how stocks, bonds, and commodities have previously done. Between 1927 and 2012, the Standard & Poor’s 500 Index returned 9.8 percent annually. A broader measure of the total U.S. stock market also returned 9.8 percent per year during that period.1
This statistic is not a very difficult one for economists to find. After all, careful records have been kept by most stock markets for a very long time. Indeed, since the computer age began, the study of historical pricing of stocks and markets has been pretty darned easy to do: The data are already in the computers and need only be retrieved and analyzed.
Based on that analysis, we know that 10 percent, give or take, is about as good as it gets over the long term. Although there have been wild swings up and down along the way, approximately 10 percent per year
has been the historic stock market average return.2 It is also not a bad number to use when guesstimating about your long-term return on stock investments going forward.
The Historical Average Return on Stock Investments Is a Very Good Result
The good news is that 10 percent is a wonderful rate of return. It will double your money in about seven years and (if you can live long enough and avoid taxation) grow your money to 128 times your initial investment over approximately half a century.
The other side of the coin is that all those ads and unsolicited calls and excited conversations with random stockbrokers, which often promise returns significantly better than 10 percent, are so much baloney. A call from somebody claiming to be able to provide dramatically better returns than that, without undue risk, is less a moment of opportunity than a warning bell telling you to walk away.
Seeking Higher Than Market Returns Is Called Gambling
Notice that I said “without undue risk” in denouncing promises of greater than historical returns. It is not hard to construct a portfolio (or even a single investment) that can return dramatically more than 10 percent per year if things go your way. The problem is that as the promise of return goes up, the level of risk goes higher, and thus the odds of things going your way grow longer and longer, or worse and worse. Eventually, you are facing a situation that is little different from somebody offering to take your money to Las Vegas and play roulette on your behalf.
Speaking of gambling, this idea of 10 percent returns on stock investments is strictly about average returns for long-term investments.3 Nobody knows what stocks will do next month or next year, and, as a consequence, stock investments over shorter time periods are just plain gambling. You should no more put your short-term money into stock investments than take it to a casino.
To make this point more dramatic, let’s look at three very big drops in stock market valuation. During a 694-day period in 1973 through 1974, stocks, as measured by the Dow Jones Industrial Average, lost a startling 45 percent of their value. In October 1987, the Dow Jones Industrial Average lost almost a third of its value in less than a month.4 And by March 6, 2009, the Dow had dropped an astonishing 54 percent over a period of 17 months. These historical facts help remind us of the very great risk of stocks for the short term. Ignore that risk at your own peril.
Not only is 10 percent per year a reasonable rough target for long-term stock returns but also it can help you filter information. When approached by people selling investments they claim will appreciate at a considerably greater than historical rates, you should recognize them as the snake oil salesmen that they are. Thus can historical information be useful to you here and now.
Chapter Summary
Long-term returns are easy to research.
Although nobody can know future returns, the historical 10 percent figure forms a good basis for an educated guess.
Investing in stocks over short periods is essentially gambling.
People promising returns significantly above historical averages are best understood as snake oil salesmen.
Notes
1. Center for Research in Security Prices, University of Chicago.
2. For a careful and detailed discussion of historical returns, see the superb book by my colleague Jeremy J. Siegel, Stocks for the Long Run, 5th ed. (New York: McGraw-Hill, 2013).
3. Jeremy Siegel, Stocks for the Long Run, 5th ed. (New York: McGraw-Hill, 2013).
4. Burton Malkiel, A Random Walk Down Wall Street: The Time-Tested Strategy for Successful Investing (New York: W. W. Norton, 2007), 187.
Chapter 33
Costs Are Important—They Reduce Your Returns
All investments have costs associated with them. The rule against free lunches is ever present, and nobody works without compensation. Thus, buying a stock, holding a mutual fund, taking out a CD from your bank, buying real estate, or keeping gold coins in a safe deposit box all cost money. These are the questions to focus on: (1) How much are we told these transactions will cost? (2) Are there hidden costs that we are not informed of or are somehow concealed from our view?
Higher Costs Result in Lower Returns
Economists know this simple truth: The more one spends on the making of investments, the correspondingly less is the return. Consider two mutual funds that invest in exactly the same way but charge different operating fees. If one charges 2 percent per year, the other charges 1 percent, and the returns from the underlying investments are the same, the first will have a real return that is 1 percent lower than the second.
This is easy to understand in the supermarket yet, somehow, more difficult to follow in the world of money. You wouldn’t buy the apples from Chile at a higher price if the same type of apples, just as delicious, were in season locally and selling for a lower price. It stands to reason that you would not want to buy investment vehicles that have higher costs or fees if a very similar one imposing lower costs is available.
Just as you do in the grocery store, search for the better value when choosing where to put your money. Most investment vehicles have a number of very similar (or identical) cousins. Indeed, there are many instances where two equivalent investments differ primarily in the fees that each charges. The universe of things to invest in is smaller than it looks. It is true that there are thousands of companies to buy stock in, many countries you can lend your money to, plenty of real estate you can own, and a bunch of currencies, rare metals, and natural resources you can speculate on. The total number of possible investments is magnified many times over, though, by a vast army of investment vehicles that invest in essentially the same things.1 This is an inconvenient truth for investment firms.
Thousands of financial jobs on Wall Street involve new ways to package or slice up the various real investments that already exist. Firms spend a lot of time explaining why three animals each with the head of a dog, the torso of a pig, and the tail of a fish are much better than one dog, one pig, and one fish. And they produce hundreds of so-called new investments each year. In examining their wares, though, extreme caution is called for. No matter which way the butcher slices a pound of baloney, it is still, in the end, just a pound of baloney.
Many Investments Carry Expenses That Are Just Too High to Be a Good Deal
It is fair to generalize that the more management, engineering, or salesmanship is involved in a complex investment, the higher its costs are likely to be. Indeed, some of these products carry such high fees that their sellers dare not be up front about them. Lots of investments have some (or all) of the costs hidden in various ways. As a general rule, investments with hidden costs are investments with costs that are too high.
One particular fee warrants special notice because it is critical to small investors. Many mutual funds are sold with sales charges called loads. These loads are often between 3 and 6 percent of the amount you are investing in the fund, above and beyond the underlying operating fees that all mutual funds charge. The load money does not go into your investment but, rather, compensates the people and companies that sold you the fund. There are other mutual funds that do not charge such loads and are known as “no-load” funds. Lots of studies have been done and economists are quite clear on this: Mutual funds with loads do not perform any better than no-load funds. Funds that charge high fees, such as sales loads and excessive brokerage charges, are almost guaranteed to underperform. After all, they must overcome the drag of those high costs just to stay even. One of the simplest and most profitable things you can do as an investor is work to avoid high costs.
Figure Out How Much You Are Paying to Those Who Lay Hands on Your Investments
Just how much are your investments costing you? It depends, of course, on how you invest and which companies you hire to handle your money. In some cases, though, the true costs of investments may be hidden far from view in operating expenses, trading fees, sales charges, management fees, 12(b)(1) charges, and on and on. Since economists tell us that such costs reduce returns dollar for
dollar, it is very important to get a handle on the true price tag of what you are doing with your money.
How You Can Minimize Costs
There are several things you can do to hold down the costs of your investments. First, decline to do business with high-cost investment companies, including not only funds with high operating expenses and other charges but also tricky companies that appear to be concealing their true fees. If they seem to be hiding the ball from you on expenses, you can bet it is because their overall charges are higher than they ought to be. The second thing you can do is just say no to sales charges and loaded funds; stick to the no-loads. Third, avoid trading in your investment portfolio to sharply reduce your costs.
Wall Street has worked hard to instill in us the idea that trading is somehow a good idea. Actually, it is a terrible thing to do more than minimally. Purge the very word from your mind. You don’t want to trade; you want to invest. And to do that prudently, you need to create a solid, diversified, low-cost portfolio and keep it. Of course, you will want to make minor adjustments as your circumstances change (and your circumstances will change; if nothing else, each year you are a little older and probably in need of a slightly more conservative asset allocation). Trading swells costs, causes tax recognition, and inappropriately wastes your mental energy. Economists know that we cannot better our overall situation by significant trading (it is, after all, an attempt to beat the market), and the trader must bear the extra costs.
Negotiating Your Investments Page 25