Buy and hold index funds

There is an investment strategy so powerful that Nobel laureates in economic science employ it — but so simple that you can use that same strategy with a minimum investment of only $250! That strategy is:

Buy and hold index funds.

Wait! Don’t go! There are usually two responses to this, and both are wrong. One response is “I’ve heard all this before.” The other is “That’s too complicated for me — I don’t even know what an index fund is.” Here’s why they’re wrong:

  • I have corresponded and spoken with many people whose reaction is “I’ve heard all this before.” They haven’t. Most often, they have been fed some half-baked slogans against index funds, and that’s all. I have yet to meet a fully informed investor who believes that it’s easy to top the results of buying and holding index funds.
  • If you think this is too complicated to figure out, read through just a few paragraphs more. I think you’ll change your mind.

Before you ever start investing, there are some first steps that you need to take. My book, Getting a Grip on Your Money, will show you what to do in some detail. Briefly, your object is to get your finances in order so that you can leave your invested money alone. You have to give it time to work; it won’t do much for you if you’re always snatching it in and out of the market.You’ll need to establish some goals, get control of your budget, and get your insurance in order first.

If you haven’t done any of this, then start with my Chapter 1, “Declare Victory,” the first of the steps to simplify your finances and prosper. But don’t wait too long! Time is on your side when you invest, so invest early and often, even if it’s not a big amount at any one time.

Key fact: A mutual fund can invest in stocks by pooling the money of individual investors, then in effect buying stocks on their behalf.

There are lots of good reasons to buy many different stocks rather than just one or a handful. But if you set out on your own to buy a set of stocks, you’ll face brokerage commissions and other expenses. Especially for small investors, this is why a mutual fund is often better then directly buying stock.

When you send your money to a mutual fund, the fund pools your money with that of many other investors, then puts the money into the stock market. You share in the gains and losses of the fund, according to how much money you have put in.

Key fact: Typical mutual funds incur a lot of cost trying to find stocks that will return more than the market (“beat the market.”).

Some mutual funds are actively managed, meaning that their managers try to pick stocks that will do better than the general market, or “beat the market.” It’s costly to hire analysts and trade frequently trying to beat the market.

How do they know when they succeeded in beating the market? They calculate how well their fund did, then compare that with how well an index of stocks did. An index is a collection of stocks. Indexes are averaged using different methods, but the intent is the same: to indicate how “the market” is doing.

For example, the Dow Jones Industrial Average is an index made up of 30 stocks. The performance of the Dow Jones is widely reported and you can easily calculate whether you’re “beating the Dow.”

You could make your own holdings duplicate the performance of the Dow Jones by buying small amounts of the 30 stocks in the Dow, in the same proportion they’re in the Dow. Of course, you’d spend a lot on commissions and transaction fees.

Key fact: An index fund avoids the cost of trying to beat the market, by just matching the market.

The Standard and Poors 500 is a collection of 500 big stocks. You could duplicate its performance, too, just by buying small amounts of those 500 stocks in the same proportion they’re in the index. But you would have to pay the commissions and fees associated with buying 500 different stocks! That would be impractical for a small investor.

Here’s where an index fund comes in. As a special kind of mutual fund, it pools funds from you and other investors, then invests the money in the stocks that make up an index. Because it has millions of dollars to deal with, it avoids the high commissions and fees that would be faced by an individual investor. Better yet, it can easily invest in 500 or more stocks.

So if you invest in a Standard and Poors 500 index fund, you’ll get something like the average return of those 500 stocks. Some will do well, some will do poorly, and you’ll get the average.

What’s so good about that?

Key fact: An index fund gives you average returns at a below-average cost. That’s why index funds usually beat conventional actively managed funds.

What matters to investors is a fund’s net return. If a high gross return is eaten up by big expenses, that means a low net return — your bottom line. With an index fund you get average returns, by definition. But you get to keep a bigger part of those average returns, because your fund hasn’t incurred big expenses trying to beat the market.

Key fact: In most years, index funds outperform more than half of the actively managed funds.

Sometimes conventional actively managed funds do well. Their managers spot good stocks, buy them up, and hold on to them long enough for superior returns. But they incur expenses in doing this. In most years, these funds don’t do well enough to outperform the indexes.

The investment firm Standard and Poors keeps a regular scorecard of how well actively managed funds do against the indexes. The scorecard is called “SPIVA.” Go on over to that link and check for yourself. The last time I checked, an astounding 86 percent of large-stock mutual funds underperformed their index. There are some technical reasons why that figure is a little exaggerated, but the basic truth remains: In most years, actively managed mutual funds do not beat index funds.

Key fact: It is very difficult to find any investment strategy that outperforms buying and holding index funds.

This is one of the most obvious facts among those who have carefully studied investment markets. The more you know, the more likely you are to see the advantages of holding index funds. Nobel laureate William F. Sharpe is the author of financial market theories that highlight the advantages of indexing. Sharpe was asked whether he invests his money in keeping with his own academic work:

Q: Do you invest your own money in broadly diversified stock index funds?
A: I certainly do.
Q: Do you try to pick individual stocks or time the market?
A: No. I invest in various funds covering bonds, large stocks, small stocks and international stocks.

(Source: Interview with William F. Sharpe in Classrooms and Lunchrooms.)

On the other hand, people who know less about financial markets are likely to underestimate the advantages of indexing. It’s hard to call index fund investing a “secret,” but it’s surprising how many people get inferior returns each year because they don’t know about it.

In Getting a Grip on Your Money, I promise readers to keep up with the mutual fund industry and let them know who the low-cost leader is. At the time I finished the draft of the book, that firm was the Vanguard Group of Investment Companies. That’s still true today, and I still recommend the Vanguard Group. However, there is one additional possibility to check out if you have a smaller amount of money to invest. See below for details.

One more check: Are you really ready to invest?

You’re not ready to invest unless you have gotten your insurance and banking relationships in order, taken maximum advantage of tax-deferred retirement plans and saved an emergency reserve. Remember, the strategy is to “buy and hold.” That means not pulling your money out of the market except in truly unusual circumstances.

Time for a disclaimer: This information is free and I’m not your financial adviser. I’m not getting paid by any of the investment companies. Before you invest in any fund, read the prospectus carefully. Understand that mutual funds can gain or lose value and there is no assurance that you will get your original investment back. Don’t trust anyone who claims that any investment is a “sure thing”!

If you are ready to invest, here’s what’s next. Start with a money market fund, then add a total stock market index fund and a total bond market index fund. You’ll need a $3000 minimum to open each account. To get started, either:

The specific funds you’re interested in are:

  • Prime Money Market Fund (fund number 30)
  • Total Stock Market Index Fund (fund number 85)
  • Total Bond Market Index Fund (fund number 84)

There are also good things to be said for the investment companies TIAA-CREF (of which I am a customer) and Fidelity (of which I am not). Check their websites if you’re interested in them:

TIAA-CREF

Fidelity 

But if you really want to know what you’re doing, go get my book for 1 cent plus shipping (prices may vary) at amazon.com.

 

Getting a Grip on Your Money, with special advice for new investors