Updated: Mar 11, 2021
Don't Fall for It
Have you ever watched CNBC even for just a few minutes? It's intense. On any given day, the market is either soaring upwards or plummeting in turmoil. Tech stocks may be jumping while energy stocks are plunging. Numbers and tickers fly across the screen. Some guy in a suit screams at you about a stock opportunity you SHOULD NOT MISS OUT ON!
It's a never-ending infomercial.
Wall Street professionals have built an entire industry on convincing investors that they need the help of professionals to succeed at investing. Unfortunately, most of it is smoke and mirrors.
To be fair, there are plenty of honest, hard-working investment advisors. The problem is when you are led to believe that an active investment account, managed by an advisor, is your only option to building a retirement nest egg.
You have essentially three options when considering your long-term investments for retirement. One option is to try and beat average market returns by selecting your own investments. Another option, as we mentioned above, is to hire an investment professional to select those investments for you.
There is a third option:
To take a passive approach and invest in funds that mimic the returns of the broader stock market. This last option is what we'll focus on in this article. We’ll explain why this option is the least time-consuming, least expensive, and —ironically—the most financially rewarding long-term strategy.
Creating an Investment Strategy
Asset allocation is the strategy of selecting diversified investments that will help you balance your risk and your reward. It's important not to take on excessive risk when considering your investments for your retirement.
Investing all your money in a single company is an example of not being diversified. If the company is successful, your reward may be great, but the risk you are taking is equally great. By putting all your eggs in one basket, you could easily wipe out your investment if that particular company performs poorly.
On the other hand, if you play it too safe by investing in only very low or no-risk investments, you won’t get much reward. Placing your money solely in CDs, which many banks offer, is an example of this. Your risk is extremely low. Even if the bank you are dealing with goes bankrupt, your money is protected by the FDIC up to $250,000 per person.
Unfortunately, your reward for this type of investment is less than impressive.
As of the publishing of this article, locking in your money into a CD for 1 to 2 years will provide you with an annual rate of return between 0.60% and 0.75%. That means if you put $10,000 into a CD with a 0.75% rate of return, you'll make $75 after a year. That doesn't even keep up with inflation, which averages around 2 to 3% a year.
Finding the Balance between Risk and Reward
You'll want to come up with an asset allocation mix somewhere in the middle of those extremes. A good place to start is by taking Vanguard's Risk Questionnaire here. It takes around 5 minutes and will provide a starting point for your asset allocation mix. Your results from the questionnaire will recommend one of the following asset allocation models:
Once you have an idea of what your asset allocation mix will look like, it is time to select individual investments for your portfolio. Your choice really boils down to whether you are going to try to beat the market or mimic the market.
This is known as active versus passive investing.
You might assume that a passive approach to investing will result in lower returns than a more active approach which selects specific investments in an attempt to beat average market returns.
Surely I have a better chance of making more money buying and selling individual investments, right?
The little-known truth is that not only do most individual investors not perform as well as the overall market, but the vast majority of professional investment advisors do not consistently beat the S&P 500 over the long term.
In fact, they’re not even close.
The SPIVA Institutional Scorecard was created to evaluate an active versus passive investing approach. The most recent SPIVA Scorecard compared how actively managed funds performed against the S&P 500 Index. Over a 15-year period, over 90% of actively managed large-cap funds underperformed the S&P 500.
That’s a shocking statistic.
In Burton Malkiel’s book, The Random Walk Guide to Investing: Ten Rules for Financial Success, he uses the following analogy :
Fortunately, there’s a way for you to avoid underperforming managed funds and still enjoy the benefits of the overall stock market.
What is an Index fund?
A "general fund" is comprised of hundreds or thousands of stocks and bonds in a single holding. This can help considerably when diversifying your investments.
Index funds specifically will aim to mirror the performance of an index such as the S&P 500, the Nasdaq, or the Dow Jones Industrial Average.
When these market indexes increase or decrease, the index fund mimicking them will do the same. Index funds are considered passively managed funds since the manager of these funds will buy most or all of the stocks within an index.
Investing primarily in index funds is considered a passive approach since it removes the need to constantly check in on your investments. Actively managed funds are different in that these funds try and beat the market and have portfolio managers buying and selling investments constantly.
As John Bogle, founder of Vanguard, used to say “Don't look for the needle in the haystack. Just buy the haystack!”
How to Invest in an Index Fund
Preferably, you are starting with a tax-advantaged account like a 401(k) or an IRA. This way you don’t have to pay transaction costs or capital gains taxes like you would on a regular taxable investment account. Below are some examples of some popular index funds to help start your research on.
How Many Funds Do you Need for a Diversified Portfolio?
Let's discuss the world's largest index fund, The Vanguard Total Stock Market Index Fund (VTSAX). This fund tracks the entire U.S. stock market. There are several reasons to love this fund. For one, it includes over 3,600 individual companies that are valued in total at $1.1 trillion as of January 1st, 2021. That is a well-diversified mix. The image to your left is the diversification breakdown for each sector as of January 31st, 2021.
Second, it is cheap. Your fee (expense ratio) is 0.04% per year on the value of your portfolio. Many actively managed funds are 1% or more. That is 25 times more expensive. High fees will eat away at your returns over time.
Third, it has provided an average annual return of 7.82% over the last 20 years—a return that 90% of investment professionals cannot beat.
There are, of course, still risks to take into account, as you would when investing in any stock or fund. There are years that the market performs well and years the market performs poorly. If you have a decade or more until you retire, then the key during turbulent times is to focus on the long game and keep in mind that over time the market has always gone up. If you are nearing retirement, a finer tuned strategy is necessary which takes on less risk.
Another consideration for this fund, and many of Vanguard's funds, is that they require a minimum initial investment of $3,000. After the initial investment, you can invest in smaller increments, but this can be a barrier to entry for many. A cheaper alternative is the exchange-traded fund, VTI. Although this exchange-traded fund (ETF) has a slightly different mix of investments from VTSAX, they both track the total U.S. stock market and provide comparable returns. The cost of 1 share of VTI as of March 1, 2021, is around $200, which is all it would take to start investing.
Early in your career when you have a long time horizon for investing, an argument can easily be made for a single index fund that tracks the overall market. However, Vanguard will suggest a mix of both stocks and bonds to better balance out your portfolio. If you would prefer to use the recommended asset allocations that the Vanguard questionnaire suggested, you can also invest in large bond funds. Here is a list of sample bond funds to consider in your research:
You can accomplish your stock-to-bond asset allocation mix with as little as two funds.
Focus on the Fees
The index fund above is just one example of a well-diversified, low-cost index fund. Once we decided to invest in index funds it removed a lot of the hard work of picking and choosing investments.
One of your primary focuses should be on fees, otherwise known as expense ratios. The expense ratio is the annual fee it costs to run the fund. These fees are automatically deducted once you invest in the fund. Keep in mind that these aren't necessarily all the fees that you would pay for the fund. An actively managed fund may have additional advisor fees. Therefore, it is important to confirm whether you'll be charged any additional fees.
One percent may not sound like a lot of money when you are thinking in terms of 100% of your assets, but that is not the comparison you need to make. What you really need to compare is the return on your investments every year. If you consider what the market average return is, you are looking at making 5 to 7% per year on your investment. So, if you’re making a 5% a year and you have a 1% fee that you are paying, that means you are losing 20% of your return per year to advisor fees.
NerdWallet’s analysis on fees here does a great job of illustrating how much a 1% fee will cost you over time. In their example, they assume you have $25,000 in a retirement account and you add $10,000 a year to the account with an average 7% annual return. They show that a 1% fee charged on your investments over 20 years would cost you almost $62,000.
The cost of fees continues to accelerate. Over 30 years, that 1% fee will cost you approximately $210,000 in fees. If you held your investments for 40 years with a 1% fee, you would pay over $592,000 in fees alone.
So the next time someone tells you a 1% fee is a small price to pay for financial advice, remember that you are actually paying 15 to 20% on your average return every year. Whether they are financial advisor fees or mutual fund fees, keeping these fees as low as possible is one of the most important choices we make as insightful investors.
Disclaimer: Using index funds as our primary investment strategy is our personal approach to investing, but it is up to you to perform your own due diligence on the subject. Your personal goals, current financial situation, and what stage in your career you are in are all factors that will affect your investment strategy. Although we do not use a financial advisor to buy and sell our investments, a professional advisor should play an important part in your retirement strategy. Financial advisors can be a great tool to help you understand the tax implications that come with investing in different accounts. Click below to learn more about our disclaimer policy.