People Don’t Know what to do with their Money
I hear from a lot of people who simply don’t know where to put their money. They may already have a 401K at work that provides them with a company match on pre-tax dollars, but they may also want to invest post-tax dollars in a Roth IRA or an Individual Account, but aren’t sure what to actually invest that money in.
Unfortunately, what usually happens is they follow the media hype and start trying to pick individual stocks. While there is no doubt that picking the right stocks can be fruitful, it is pretty difficult for the average Joe to put in the time needed to “effectively” do so while working a full time job.
What does the Oracle of Omaha Recommend?
Warren Buffett, CEO of Berkshire Hathaway Inc. famously made a $1 million bet that he could beat any hedge fund over a ten year period by simply investing in an index fund that tracks the S&P 500. So imagine all those Hedge Fund managers that do nothing but brag about how much money they will make you… they must have been lined up at his door to take his money right??? Silence…… Crickets,,,,,,. Hmmm…..
Finally, a money-management firm (Protégé Partners) said they could do it, and took him up on the bet. Buffet chose a Vanguard index fund that tracks the S&P 500, while Protégé Partners decided to choose the average of 5 specific Hedge Funds. Well, we’re over nine years in and Buffett is absolutely crushing it. As of this writing the index fund is up 85%, while the average gain of the five hedge funds is up only 22%. The best performer of the five is only up 62%, significantly behind Buffett’s plain vanilla S&P 500 index fund. The worst of the five hedge funds was only up 2.9%. Yeah, you read that right,,, it took 9 years to get a 3% gain! What the heck did they invest in,,, snowboard shops in Texas???
Invest as well as the Pros, with Index Funds?
So how can a single index fund beat the World’s smartest money managers over a ten year period? Why it’s elementary…. Fees. Buffet chose an index fund that would simply track the S&P 500, and do it with very low fees. An index fund that does that, like Vanguard’s VOO, currently has an expense ratio of .04% annually. That means investors are only charged $400 per year for every $1,000,000 invested. A typical hedge fund fee is 2%, meaning that same $1,000,000 invested might cost you $20,000 to have actively managed.
If you think about how much those fees add up to over ten years you start seeing why it is difficult for hedge funds to beat an index fund in the long term. If the market goes up 4% for the year, and your fund manager charged you 2%, you basically just lost half your profits. That sucks!
It’s all about Diversification and Low Fees
Diversification can reduce your rewards, but that is only because it significantly lowers your risk of loss. If you buy two stocks and Stock A doubles in value, while Stock B goes to Zero, then you are right back where you started. Some might say, “Well, that means diversification doesn’t work because I could have doubled my money if I just would have bought Stock A.” Others might say, “Holy crap… thank God I bought two different stocks, because if I just would have bought Stock B I would have lost everything I own.” Of course the wise man would say, “Why are you morons only buying two stocks when you can just as easily buy 2,000?”
Now you have to ask yourself, if the smartest guys in the room can’t consistently outperform the market enough to overcome a couple percentage points… How realistic is it that you are really going to do any better with your individual stock picks from now until retirement?
Buying Index Funds is Easy:
If you aren’t familiar with ETFs (Exchange Traded Funds). They simply track a basket of stocks or follow an index all while being bought or sold like stocks. In other words if you want to buy all the stocks in the S&P 500, all you have to do is buy shares of VOO. Yeah, it’s that easy, you just need to setup an account with an online broker, many of which can be opened with as little as $100, select your ETF(s), and hit buy. Leave it there until retirement. Tadaaa…. Not that hard.
4 popular low fee index funds:
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C.J. is the blogger behind the Vow of Practicality. “Let’s grow your wealth, increase your productivity, and maximize your happiness.”