The Washington Post repeats a common theme: that small investors were the hardest hit in a stock market selloff. The story has an appealing logic. When there is a big market move and small investors are trying to get their trades executed, they may well get locked out by the fat cats who dominate trading on Wall Street.
Here’s how the Post describes the problem:
Popular trading platforms run by TD Ameritrade, Scottrade and others ran slow or not at all as panic grabbed hold. It took just six minutes for the Dow Jones industrial average to suffer its biggest drop in history. And these investors could only watch.
What the Post misses is that smart small investors were not hurt at all. Why? Because smart small investors assume in advance that they cannot play the game of timing the market or beating the market. Instead, they buy and hold index funds. That’s a hard strategy to beat over the long haul.
Dumb small investors were undoubtedly hurt. They were trying to pull their money out after widespread predictions that Monday would be a bad day on Wall Street — and they just couldn’t sell because the system was jammed. However, had they succeeded in selling on that Monday, for most of the day they’d have gotten a far worse deal than if they had waited until later in the week.
So: Get your budget in order as I describe in my book, only invest money in the stock market that you can afford to keep invested, and don’t worry about flash crashes.
You’ll occasionally see articles like this one claiming that it’s relatively easy to exploit index funds with the following strategy:
- Figure out which stocks will be added to a widely tracked index, such as the Standard & Poors 500.
- Buy them before they are added.
- And then sell them when they’re added to the index, at a time when index funds are required to add them also, pushing their prices up.
So, does that mean “buy and hold index funds” is a bad strategy? Hardly. The index funds know about this (surprise!) and so they begin building their holdings of likely index additions well in advance. The loss to index fund investors is minimal, leaving index fund returns still well above the averages and the alternatives.
In that same article you’ll notice the recommendation of two analysts to buy total market index funds to get around the problem:
Petajisto and Morningstar’s Rawson also suggest passive funds that buy the entire market can minimize the damage of front-running. By owning almost every stock, there’s barely anything for arbitragers to buy first.
The fund they cite is the exact one I recommend, the Vanguard Total Stock Market Index fund. The conclusion — you’re not surprised, are you? — is: Buy and hold index funds.
Several times when I was growing up, my family visited others’ vacation homes — Uncle Claude’s beachfront house at Gulf Shores, a business friend’s cabin on the Savannah River, Jim and Mary Louise’s place on Lake Martin. I thought how neat it would be to have a vacation home when I grew up.
Later in life, I came to a different perspective as some of my wealthier friends began to buy vacation homes. They were always worrying about something. Did that last storm damage the lake house? Or, by the fireside at home in December: Did we remember to drain the plumbing, or are the pipes freezing even now, setting off a disaster? When vacation time came, there was only one place they could go — because they had so much money in it.
Being an economist, I started to reflect: What did I like so much about vacation homes? My short list of answers: the casual interiors, the open floor plans, the use of natural finishes and the wood stoves and fireplaces.
Then is when it hit me: I have a vacation home. Our (only) home has everything I would want in a vacation home (such as those natural wood finishes and wood stove). This all came about through various decorating and interior decisions over the years. We get to live causally at our place year round. We don’t have to worry about the maintenance or cost of another home. When we go on vacation, we usually go for a lakeside cabin rental. When our vacation ends, we pack up and go, happily leave the off-season maintenance to others. And then we return to our year-round vacation home. How’s that for a brilliant vacation home strategy?
Smart cellphone customers use prepaid plans. These plans offer better value than traditional postpaid plans. Most such plans work the same way — you just pay before the month’s service instead of after.
The very best deals are for consumers who pay up-front for unlocked phones and then buy a prepaid plan. Just slip in the SIM card and you’re in business. Because the carrier hasn’t subsidized the cost of your new phone, it doesn’t have to build in monthly charges to recover that cost. (Do the math and you’ll find a “free” phone is very costly by the time you’re done with a two-year contract paying for it.)
For the past few years, the very best deal of all was to buy an unlocked Google phone that used the “GSM” standard — because AT&T, T-Mobile and foreign carriers all supported GSM. You could switch from AT&T to T-Mobile and back just by changing SIM cards. Instead of a monthly charge, you could have a pay-as-you-go plan and save even more money — especially if you spend most of your time around free Wi-Fi networks. One excellent plan by AT&T’s GoPhone charged $5 for 50 megabytes a month. That’s not much data but it’s enough for a cautious user who’s around Wi-Fi a lot.
That plan is no longer available, but there is a $25 per month plan that offers 50 megabytes of data per month for $5. It competes directly with T-Mobile’s $30 per month plan. There are differences in the included voice minutes and messaging, so check both plans if you’re thinking of going this route.
In my family, we have two T-Mobile prepaid plans, one Tracfone and one GoPhone plan on a Nexus phone. The beauty of an unlocked phone like the Nexus is that you can go get a compatible (T-Mobile or AT&T) SIM card for it and switch carriers just that easily.
Summary: Prepaid service with unlocked phones is the best; with an unlocked phone you can easily go to another carrier.
but it is still best to buy and hold index funds.
Mid-year is a great time to do a financial checkup. You can multiply spending, income and tax totals by 2 to get an estimate of what the whole year will look like financially for you. You can also check on your income tax withholding to see if it’s about right.
If you’re paid regularly, just take a look after your June 30 or July 1 paycheck and multiply your “income to date” and “federal tax withheld to date” by 2. That gives you a rough estimate of what your year-end income and taxes look like. If your year-end income looks a lot higher than last year’s, you can have more tax withheld. That increases the probability that you’ll get a refund instead of having to pay more when you file taxes next year.
Here are a few more points to keep in mind:
- This exercise works best if you’re paid a regular salary. It’s much less valuable if your pay goes up and down a lot.
- If you want to get a little more precise with your withholding calculation, there’s a handy calculator at TurboTax.
- If you want to make sure you don’t owe penalties or interest when you file your taxes next year, check out the Safe Harbor Rule, so that you can remain OK even without a good estimate of the next six months’ worth of income.
- Although a big tax refund might look nice, keep in mind that such a refund is vulnerable to identity theft. Caution would argue for not letting so much money accumulate in tax withholdings.
There’s always another reason for small investors to stay out of the individual stock investing game, but this point sometimes produces an unusual twist. From watching 60 Minutes or Today, you may think small investors are being disadvantaged by high-frequency trading. They might or might not be. Here’s an author who thinks they’re not hurt. But an incidental point in the article is raised by a former chief investment office at my favorite mutual fund company. Here’s the key point: “Rather than decrying speed traders, Sauter praised the benefits it had brought to him and his clients. By his estimate, speed traders helped him save him more than a $1 billion a year.” Improvements in the technical efficiency of markets help those who buy and hold index funds.